Oil price and US Treasury yields in tightest relationship since 1990
Bond investors watch Iran conflict and crude price for signs as to where government borrowing costs will go
Oil prices and US Treasuries are locked in their tightest relationship since the first Gulf war in 1990, as the Middle East conflict increasingly drives the bond market that helps set borrowing costs across the global economy.
The correlation between the price of West Texas Intermediate crude and the 10-year Treasury yield hit 65 per cent this month, according to derivatives firm Cboe, putting it within touching distance of the level set following Iraq’s invasion of Kuwait nearly four decades ago.
The closeness of the relationship highlights how dependent the outlook for the global economy and major asset classes has become on traffic through the Strait of Hormuz, through which about 20 per cent of the world’s oil exports usually pass.
The energy price shock has forced investors to rethink their approach to the market as they price in higher inflation and interest rates.
Bond investors usually “dig into countries’ economic data releases and their central bank announcements in microscopic detail”, said Mike Riddell, a fund manager at Fidelity International. “For the last three to six months, we’ve basically just been oil traders.”
The correlation between oil and Treasury yields hit a record of 66 per cent in 1990, in Cboe data going back to 1985. Bond yields move inversely to prices.
The close correlation can also be seen across European bond markets, where yields for countries more exposed to the energy shock have moved higher in tandem with the crude price.
Yields are moving “basically tick-for-tick with the oil price this year”, said Richard Woolnough, a bond fund manager at M&G.
Oil price benchmarks have swung wildly during the Middle East conflict, seesawing between well over $100 and about $70 per barrel as the prospects of a negotiated peace ebb and flow.
The US 10-year yield, a benchmark for trillions of dollars in assets worldwide, has soared to its highest level since 2007 this year, as the fallout from the US-Iran conflict — combined with a strong domestic economy — adds to fears of higher inflation.
That has prompted traders to increase their bets that the Federal Reserve will have to raise interest rates.
Each extra dollar on the price of a barrel of WTI is equivalent to almost 0.02 additional percentage points on the 10-year yield, according to calculations by analysts at TS Lombard. On Monday, oil rose as much as 4.5 per cent, while the yield on the 10-year Treasury climbed as much as 0.09 percentage points.
As the conflict has rolled on since February, investor hopes have faded that central banks would overlook a temporary supply-driven surge in inflation. Instead, higher energy prices are increasingly seen as the last straw for central banks grappling with above-target inflation.
Fed chair Kevin Warsh this month said “inflation is too high and has been for too long” as the central bank increased interest rates for the first time since 2023.
“The driver of front-end yields has changed” this year, said Peter Schaffrik, global macro strategist at RBC Capital Markets. “You now have a very specific, identifiable driver of central bank policy,” he added, referring to energy prices.
As a result, investors say that changes in economic fundamentals such as growth and inflation have taken a back seat to oil as a driver of bond prices.
“That transmission mechanism is quite cloudy,” said Lauren Van Biljon, a senior portfolio manager at Allspring Global Investments. “It makes timing difficult.”
Mandy Xu, head of derivatives market intelligence at Cboe, said: “If this pattern holds, then where yields go from here will be less dependent on the Fed and more on the situation in Iran.”
For Europe, soaring gas prices have been equally closely watched, given their greater importance to household inflation. European natural gas prices are up 160 per cent this year to the highest level since the aftermath of Russia’s full-scale invasion of Ukraine.
European Central Bank president Christine Lagarde highlighted the rising gas prices as an upside risk to inflation when the central bank raised interest rates earlier this month.
The outlook for the conflict itself remains uncertain, with Donald Trump on Saturday saying he had rejected Iran’s offer of a new seven-day ceasefire.
“For the first time since the start of the Iran conflict, we don’t have a baseline view” on where oil will go, wrote JPMorgan analysts led by Natasha Kaneva, head of global commodities strategy, in a widely circulated note last week. “We simply don’t know how to model the endgame.”