Bond Market in Oil’s Grip Ponders Shifting Focus to Growth Worry

Bond investors are starting to ponder whether the inflation worries sparked by the Iran war will soon tip over into concern about the risk to economic growth from elevated oil prices.Author of the article:You can save this article by registering for free here. Or sign-in if you have an account.(Bloomberg) — Bond investors are starting to ponder whether the inflation worries sparked by the Iran war will soon tip over into concern about the risk to economic growth from elevated oil prices.Subscribe now to read the latest news in your city and across Canada.Subscribe now to read the latest news in your city and across Canada.Create an account or sign in to continue with your reading experience.Create an account or sign in to continue with your reading experience.For now, with crude around the most expensive since the aftermath of Russia’s invasion of Ukraine in 2022 — the last time US Treasuries and oil were correlated this closely — the threat of hotter inflation is top of mind for investors. And it will likely be for Federal Reserve officials as well when they meet this week. However, as the war enters its third week, with bets on Fed interest-rate cuts fading, chatter is building around the prospect that soaring energy prices will eventually depress the economy, at a time when the labor market and consumer spending are already showing cracks.Get the latest headlines, breaking news and columns.By signing up you consent to receive the above newsletter from Postmedia Network Inc.A welcome email is on its way. If you don't see it, please check your junk folder.The next issue of Top Stories will soon be in your inbox.We encountered an issue signing you up. Please try againInterested in more newsletters? Browse here.Against that backdrop, Priya Misra at JPMorgan Asset Management says 10-year yields at or above 4.25% — up from 3.94% at the end of February — start to look appealing.“You never want to catch a falling knife,” said the portfolio manager. “But when the market has done a lot of that repricing, positions are cleaner, this might be the time when you position for that growth shock that typically follows the inflation shock.”Misra’s stance captures the tension that’s building in the bond market, between reacting to the initial oil jolt and anticipating the extent of any subsequent hit to growth. The debate around which dynamic will prevail is potentially setting up the defining trade in Treasuries over the next few months, as it suggests there’s scope for a bullish shift that forces traders to price in more Fed easing, dragging yields down again.March TurnaroundThis month’s selloff marks a big turnaround for Treasuries, which rallied in February in part on concerns that artificial intelligence could disrupt some industries.Inflation fears have become paramount since the US and Israel launched strikes on Iran, and as Iran retaliated. Brent oil, the global benchmark, was around $103 at the end of last week. That’s up about 40% from the end of February, adding pressure to already hot inflation. That jump puts the Fed — which hasn’t met its 2% inflation target for half a decade — in a bind. While not every major oil shock has preceded a recession, the most serious US economic downturns have followed a sudden spike in energy prices – including in 1974, 1981, 1990, 2001 and 2008, according to Dario Perkins at TS Lombard.Morgan Stanley strategists told clients on Friday that Treasuries are “ripe for a demand-destruction-induced reversal.” They pointed to the 1-year forward 1-year inflation swap rate for clues as to what oil price might lead to cooler, not hotter, inflation.“Once higher oil prices no longer lead to higher 1y1y inflation swap rates, but rather lower rates, we think investors should go overweight US Treasuries,” they said.What Bloomberg strategists say…For the oil market to clear in the wake of supply disruptions, prices have to rise enough to force a reduction in demand. And demand will only fall if economic activity slows and growth declines. That makes this a textbook stagflationary shock, where it’s still unclear which force — slower growth or higher inflation — is the driver.-Edward Harrison, macro strategist, Markets Live. For the full analysis, click here.One thing traders will watch from the Fed this week is whether officials stick to their December projection for one 2026 rate cut. The swaps market is now pricing in less than one full Fed easing this year, whereas two weeks ago it was leaning toward potentially three. Options pricing even shows more than a 20% probability of a hike by December, data compiled by the Atlanta Fed show.Strategists at Barclays Plc say markets may be underappreciating the growth risk. They recommended a slew of bullish bond positions last week, including going long December 2027 futures on short-term interest rates to bet on more Fed easing than markets anticipate.James Athey, a portfolio manager at Marlborough Investment Management, said he increased US bond exposure after the recent selloff, and said Fed cuts may be delayed but not derailed.“We are definitely flirting with the more pernicious outcomes for the oil price,” he said. “If that is where we are headed then I think it should be treated as less of an inflation shock — which is what markets are pricing currently — and much more of a risk-off growth shock.”Broadly speaking, financial markets aren’t signaling major growth worries, with the S&P 500 Index just around 5% below its January record high.A 2024 Fed study found that the surge in oil prices following Russia’s invasion of Ukraine pushed up headline inflation, but had only modest effects on core inflation and overall economic activity, in part because energy represents a relatively small share of US production and consumption.But the question is how long crude prices stay elevated. The threat they’ll remain high is rising, after President Donald Trump and Iran’s new supreme leader, Mojtaba Khamenei, struck defiant tones last week. And that’s raising the stakes with the economy showing signs of losing momentum.Given data showing US employers cut jobs in February and the jobless rate climbed, the market is pricing in too low a probability of Fed easing by June, said John Briggs, head of US rates strategy at Natixis North America.Two-year notes — yielding roughly 3.7%, above the Fed’s effective funds rate — are within the buying zone, he said.“It’s worth scaling into the two-year, as it should benefit from downside risks to growth,” he said.What to Watch—With assistance from Katie Greifeld and Matthew Miller.Postmedia is committed to maintaining a lively but civil forum for discussion. Please keep comments relevant and respectful. Comments may take up to an hour to appear on the site. 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