Oil Prices and the Bond Market Are Moving in Tandem. What That Means for Your Interest Rates
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KEY TAKEAWAYS
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Rising oil prices are driving up bond yields, making borrowing more expensive.
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The 10-year U.S. Treasury yield is nearing a critical 4.5% threshold, and developments in Iran could push it over the line.
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The Federal Reserve is expected to keep rates steady amid inflation risks tied to higher oil prices, which also influence bond traders’ next moves.
Homebuyers and businesses hoping for cheaper loans may have to wait for oil prices to come down.
That’s because bond markets, where mortgage rates and other long-term borrowing costs are set, are trading in line with oil prices as they swing above or below $100 a barrel.
When investors are optimistic the Iran war is ending, oil prices and rates have been falling in tandem. The opposite happens when investors expect the war to drag on, which has driven the yield on the 10-year U.S. Treasury up to 4.47% Wednesday, up from below 4% before the war. The average 30-year mortgage rate has also shot up to 6.37%, up from below 6% in late February.
Bond investors’ big fear—that inflation eats away at their interest payments—is forcing them to demand higher interest rates on government bonds.
What This Means For You
Higher oil prices are driving up borrowing costs, making mortgages and business loans more expensive for consumers and companies. This could delay home purchases and investment decisions.
It isn’t just the U.S. government that’s paying more to borrow. Bond yields are also up in Germany, the United Kingdom, Canada and Australia, according to Bob Elliott, CEO and chief investment officer at Unlimited Funds.
“At this point, pretty much every bond market is trading in lockstep with the undulations in oil prices,” Elliott wrote this week.
Not that equity markets seem to mind. Oil shocks are “insidious,” he wrote, because they pressure household budgets all while making credit less available by raising interest rates. But stock markets seem to be ignoring those pressures, with the S&P 500 index at record highs.
“Given the global nature of the equity recovery, it seems like a big, very hopeful bet that this oil shock issue has limited economic impacts,” Elliott wrote, adding it’s “a bold call given the pain experienced by the bond market.”
The 4.5% Test
There are some critical thresholds at play for bond investors, who include pension funds, sovereign wealth funds, insurance companies and your average retiree.
Thus far, the yield on the 10-year U.S. Treasury note has mostly stayed below 4.5%. That’s a contrast to last April’s tariff-driven market turmoil and 2023, when bond markets grappled with decades-high inflation.
If oil prices keep rising, that 4.5% level could be tested, wrote John Canavan, lead analyst at Oxford Economics. Since the 10-year yield is a key input into mortgage rates, that would make homebuying more expensive and refinancing less appealing.
But bond yields could also fall again if there’s a credible path to reopen the Strait of Hormuz, a critical chokepoint in global oil markets, Canavan wrote.
“The struggle for direction should continue as long as negotiations between the U.S. and Iran remain in limbo, with rates still tethered to the war’s path,” Canavan wrote.
At least on Wednesday, there was some hint of optimism in markets, wrote Ian Lyngen, head of U.S. rates strategy at BMO Capital Markets. The 10-year yield touched 4.5%, but bond traders seemed willing to buy at that level and pushed rates back down, Lyngen wrote. U.S. oil benchmarks also remain “within the orbit” of $100 per barrel, he added.
That all “implies optimism that there is some type of resolution that results in oil flowing out of the region at some point in the coming weeks—otherwise energy prices would drift higher,” he wrote.
Fed Path
The outlook for the Fed also plays a key role.
Before the war, markets were optimistic that the Fed would cut rates a couple of times this year. But now traders see the Fed more likely to stay on hold, and some fear inflation will force the central bank to hike.
The Fed’s benchmark rate is short-term, but it can translate into higher long-term yields as traders price in a Fed that keeps rates higher or not as low for the next decade.
With oil prices pushing up inflation again, the Fed will likely “keep rates unchanged for the foreseeable future,” Lyngen wrote.
The Fed “can’t cut here,” analysts at the Dutch bank ING agreed. For now, the 10-year yield may be able to stay below that 4.5% mark, since getting paid that level of interest makes it a “structural buy for many players.”
“That said, it can just as easily sail on higher, especially as there is no easing in price pressures to help calm things down,” they wrote.
Others still see Fed rate cuts coming later in the year. While the consumer price index rose by 3.8% in April, analysts at UBS expect inflation to moderate to 3.3% by year-end, paving the way for Fed cuts to continue.
While markets are focused on inflation risks, the UBS analysts pointed to the chance that higher oil prices will depress economic activity—boosting the case for Fed cuts so that unemployment doesn’t rise.
“We believe the market still underestimates the downside risks to growth,” they wrote. “Persistently higher oil prices may mechanically push inflation expectations higher in the near term, but over time they are likely to weigh on economic activity.”
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