Rising oil prices reach new highs but fail to shake the bond market's "defection" — U.S. Treasury trading logic quietly shifts toward growth concerns

Source: Zhitong Finance Network

As investors deepen their concerns that the energy crisis will drive the Federal Reserve to raise interest rates, and turn to chase U.S. Treasury yields that have reached their highest point of the year, the sell-off in the Treasury market has temporarily paused.

On Friday, the benchmark U.S. Treasury yield fell back after climbing to its highest level since mid-2025. The two-year yield, which is most sensitive to changes in Federal Reserve policy, once dropped by 9 basis points to 3.90%, having previously touched nearly 4.03%, a high since June.

Despite crude oil prices breaking multi-year highs, the bond market still saw a rebound, breaking the recent correlation between the two. Over the past month, investors have largely ignored the drag on the economy from rising fuel costs, instead continuing to push yields higher due to rising inflation expectations.

Ian Lyngen, head of U.S. rates strategy at BMO Capital Markets, stated: “The front end of the U.S. Treasury yield curve is no longer tracking energy prices as an inflation risk factor but is more focused on the downward pressure from economic growth and risk assets.”

Longer-term Treasury yields also fell back from their highs for the year. The 10-year Treasury yield still rose nearly 2 basis points to 4.43% on the day, having previously surpassed 4.48%, the highest level since July. As oil prices continue to rise due to U.S. military action against Iran (now in its fifth week), yields across maturities once touched intraday highs.

Although WTI crude oil futures closed at $99.64 per barrel, the highest level since mid-2022, short-term Treasury yields remained near their lows for the day. The global benchmark Brent crude also closed at a multi-year high.

As a result, the yield curve steepened, breaking the previous month’s trend of oil price increases accompanying a flattening curve—at that time, investors expected the Federal Reserve to respond to rising inflation.

In a report released on Friday, Lyngen noted that the market movement on Friday marks the approach of a turning point, stating, “The market’s response mechanism to further increases in oil prices will shift,” leading to a steepening of the yield curve.

Since the U.S. attack on Iran on February 28, disrupting the region’s oil supply, U.S. Treasury yields have generally risen alongside oil prices. Later on Thursday, President Trump extended the pause on strikes against Iranian energy facilities by 10 days, causing yields and oil prices to briefly retreat, although he expressed doubts about the possibility of reaching a peace agreement.

The rise in yields reflects that the related increase in U.S. retail gasoline prices may be reflected in overall consumer inflation indicators, thereby hindering the Federal Reserve’s implementation of the rate cuts that the market widely expected before the outbreak of conflict.

John Briggs, head of U.S. rates strategy at Natixis, stated that as long as the Strait of Hormuz remains closed, investors will worry about “inflation and the central bank taking similar measures to those in 2022.” The oil shock from the Russia-Ukraine conflict in 2022 contributed to a surge in post-pandemic inflation, ultimately leading the Federal Reserve to raise rates by over five percentage points before mid-2023.

Macro strategist Michael Ball remarked, “The next move for the U.S. Treasury yield curve is more likely to steepen, led by a potential reversal in front-end yields. The front-end yields have previously been aggressive in pricing inflation driven by oil prices, while underpricing the impact of rising energy costs on growth and the labor market.”

While market expectations for inflation over the next year have retreated from last week’s highs, they have surged from about 2.2% at the beginning of the year to above 3%. Swap contracts reflecting expectations for future Federal Reserve rate decisions no longer show any possibility of rate cuts this year and price in more than a 50% probability of rate hikes.

Molly Brooks, rates strategist at TD Securities, stated, “The market has completely shifted, with market participants changing from questioning when the next rate cut will come to pricing in rate hikes for 2026.”

The Federal Reserve cut rates three times last year in response to a weak labor market. Although related concerns have largely dissipated, February’s employment data still fell short of economists’ expectations.

The March employment report will be released next week on April 3 under unusual market conditions, as the stock market will be closed for Good Friday (a holiday that is not a federal holiday). The dispersed trading in the bond market will have shortened trading hours due to the holiday (if the holiday does not coincide with the release of important economic data), leaving investors with limited time to react to the data.

Friday’s market movements suggest that the U.S. Treasury market is likely to record one of its worst months in nearly five years. According to relevant Treasury indices, as of March 26, the U.S. Treasury market has dropped 2.36% this month. If this decline is maintained, it will be the worst performing month since October 2024.

Citi economist Andrew Hollenhorst stated in a report that the upward pressure on Treasury yields also stems from the outlook for increased U.S. government borrowing—both to finance war costs and to refinance existing debt at higher rates.

This week, auctions of two-year, five-year, and seven-year Treasury bonds all cleared at yields higher than expected, reflecting the average rate level demanded by investors to meet the U.S. government’s financing needs. The three auctions raised a total of $183 billion.

This is the worst performance for these three maturities in a month since May 2024, when traders similarly reduced their bets on rate cuts.

Hollenhorst wrote that Treasury auctions “remind us that fiscal challenges will worsen as rates rise,” and pointed out that “large deficits are more easily financed when the Federal Reserve is expected to cut rates,” while currently “defense spending expectations are on the rise.”