The surge in oil prices has triggered a historic reversal in market expectations for Federal Reserve policy, leading Japanese investors to exit the U.S. Treasury market at the fastest pace in nearly four years. According to the latest balance of payments data released by Japan's Ministry of Finance on Wednesday, Japanese investors were net sellers of U.S. Treasury bonds, agency bonds, and local government bonds totaling 4.67 trillion yen (approximately $29.6 billion) in the three months ending March 31. This marks the highest quarterly reduction since the second quarter of 2022. In March alone, Japan was a net seller of U.S. sovereign bonds to the tune of 2.2 trillion yen (about $14 billion), marking the second consecutive month of reduction after a net sale of 2.77 trillion yen in February.
Concurrently, U.S. Treasuries held by foreign official institutions in the Federal Reserve's custody account decreased by $8.7 billion in one week, a move widely interpreted by the market as Japan raising intervention funds through the sale of Treasuries. Data previously released by the U.S. Treasury Department showed that Japanese investors had already sold $4.14 billion worth of U.S. agency bonds in the first two months of this year, indicating that their retreat from U.S. fixed-income assets began earlier.
The backdrop for this large-scale sell-off is the sharp rise in oil prices, which has fueled inflation expectations and triggered a reversal in Fed policy forecasts. The conflict involving Iran has persistently disrupted the global energy supply landscape. On May 11th, following the collapse of renewed peace talks between the U.S. and Iran, international oil prices spiked again—West Texas Intermediate (WTI) crude briefly surpassed $100 per barrel, while Brent crude rose to $105. Previously, public statements rejecting Iran's response to U.S. peace proposals had cast doubt over any agreement and triggered significant volatility in energy markets.
By May 12th, oil prices had surged again, with WTI crude rising 2.6% to $100.65 per barrel and Brent crude gaining 2.2% to $106.53 per barrel, further intensifying market anxiety. Brent crude has since climbed above $107. Geopolitical tensions are having a profound impact on supply. Since joint military actions against Iran began, shipping through the Strait of Hormuz has been severely restricted. This critical chokepoint, handling about 20% of global seaborne oil trade, remains partially blocked, preventing significant Middle Eastern production from reaching international markets.
Natasha Kaneva, Global Head of Commodities Strategy at J.P. Morgan, noted that global crude supply disruptions have reached 13.7 million barrels per day, roughly 14% of global demand. Consequently, global inventories are being drawn down at a rate of 7.1 million barrels per day, with a persistent supply deficit of about 2 million barrels per day. More alarmingly, J.P. Morgan's latest assessment warns of an extreme scenario: if the U.S.-Iran conflict worsens, Brent crude could be pushed to $150 per barrel. Even under its base case, J.P. Morgan expects Brent to trade between $120 and $130 in the near term, with a breach of $150 not improbable if the Strait of Hormuz disruption persists into mid-month.
Fitch Ratings also expects Brent to remain in a $100-$110 range during a potential May-July blockade of the Strait, only returning to a supply-demand determined level around $70 by September.
Against this backdrop, the oil price shock has fully transmitted to U.S. domestic price levels. Data released by the U.S. Bureau of Labor Statistics on May 12th showed the Consumer Price Index (CPI) rose 3.8% year-over-year in April, the fastest pace since May 2023, exceeding both the previous month's 3.3% and market expectations of 3.7%. Month-over-month, CPI increased 0.6%, matching the median forecast from a Reuters poll of economists. Structurally, a 3.8% rise in energy prices contributed over 40% of the monthly increase, with gasoline prices up 5.4% and fuel oil up 5.8%. The core CPI, excluding food and energy, rose 2.8% year-over-year and 0.4% month-over-month, also exceeding expectations.
Worryingly, inflationary pressures extend far beyond energy. Food prices accelerated, rising 0.5% after stalling in March, with groceries up 0.7%, beef prices soaring 2.7%, and fruits and vegetables increasing 1.8%. Pressures from services, shelter, airfare, and tariff passthroughs are also evident, with shelter costs up 0.6%, airfare up 2.8%, and lodging away from home up 2.4% for the month.
Chicago Fed President Austan Goolsbee called the April inflation data "disappointing," noting that service price pressures were "most concerning" as they are less likely to be directly caused by oil prices or tariffs and instead reflect more systemic price pressure diffusion.
As the CPI data was released, traders on the prediction market platform Kalshi issued a more aggressive warning: the peak of inflation is far from over. They assign a high probability that price increases will exceed 4% by 2026, with about a 55% chance of surpassing 4.5%. They also see a nearly 40% probability that inflation will exceed 5% this year—a level not seen since February 2023. This is significantly higher than Wall Street's consensus. Economists surveyed by FactSet expect inflation to peak at an average of 3.8% this quarter before easing to 2.8% by year-end.
J.P. Morgan's base forecast shows U.S. CPI could touch 4% in May, not falling below 2% until April 2027. In a worst-case scenario where summer oil prices remain above $120, CPI could breach 5%. Seth Carpenter, Morgan Stanley's Chief Global Economist, warned: "In the first quarter of a supply disruption, an oil supply shock primarily manifests in price increases. If the disruption enters a second quarter and prices continue to climb, the 'transitory' nature of the shock begins to fade... central banks will have to pivot from delaying to adjusting their policy stance."
Even if the current fragile ceasefire in the Middle East holds and the Strait of Hormuz reopens subsequently, economists warn costs could remain elevated for months. Rising fertilizer prices will further push up grocery bills, while high oil prices will permeate broader goods and services prices through transportation cost channels.
Schuyler Werning, Chief Investment Officer at Regan Capital, noted: "The primary impact of the Middle East conflict is the shock to oil prices, which has already rapidly translated into what consumers pay at the pump. But the next frontier to watch is the rise in food and raw material input prices."
The dramatic shifts in oil and inflation have forced a historic reversal in market pricing of the Federal Reserve's policy path. Just before the conflict escalated in February, the overnight index swap (OIS) market indicated traders expected about 50 basis points of Fed rate cuts in 2026. The energy shock from the conflict has completely inverted that outlook. Interest rate swap contracts tied to Fed policy decisions now show a more than 50% probability of a rate hike by next April, with expectations for rate cuts pushed further out.
CME FedWatch data shows the probability of at least a 25-basis-point hike by December has risen to about 34%, up from 26.3% just a day earlier. Pricing has largely eliminated the possibility of any rate cuts from now through the end of 2027.
Naokazu Koshimizu, Senior Rates Strategist at Nomura Securities, commented: "A strong trend of position adjustment has emerged in the market. The outlook has become highly uncertain, not only regarding how far rate cuts might be delayed, but also whether the next move might be a hike. Previously, the market held the belief that rate cuts would materialize at some point, which supported buying behavior."
This sharp reversal is also evident within the Fed itself. Last month's Federal Open Market Committee (FOMC) meeting saw the highest level of dissent since 1992, with as many as three officials voting against the policy statement's dovish-leaning language. Even previously dovish Fed Governor Lisa D. Cook has significantly softened her stance, substantially lowering her rate cut expectations. The stance of the incoming new Fed Chair, whose formal appointment is pending, is also drawing widespread market attention, with expectations that he will face extremely challenging policy choices.
Consequently, J.P. Morgan issued a stark assessment of the global oil market, warning that supply disruptions from the U.S.-Iran conflict could push Brent crude to $150, lift U.S. inflation to 4%, and cause the Fed to hold rates steady until 2027. Goldman Sachs and Bank of America have joined other major Wall Street firms in pushing back their forecasts for rate cuts. They argue that both jobs and inflation data support the case for the Fed holding rates steady at least through the end of this year.
Amid this cross-asset turmoil, the most critical variable is the sharp climb in U.S. Treasury yields. As the "global benchmark for asset pricing," the 10-year U.S. Treasury yield profoundly influences global borrowing costs—from mortgages and corporate loans to sovereign debt. Every basis point move triggers a global repricing of assets. Currently, this "anchor" is swinging violently.
Across the curve, U.S. Treasury yields have surged. The 30-year yield briefly surpassed 5%, becoming the first long-dated bond to breach that psychological level. The 5-year yield has firmly established itself above 4%, the 2-year has climbed to 4%, and the 10-year yield has broken above 4.5%. More alarmingly, driven by expectations of soaring energy costs due to the conflict, the 10-year yield approached the symbolic 5% level this week—a threshold not seen since 2007.
The magnitude of this rise is stark when compared to its starting point. In late February, before the escalation against Iran, the 10-year yield was just 3.94%. In less than three months, the world's most important interest rate benchmark has climbed over 52 basis points.
A move of this scale has triggered a comprehensive repricing of global risk assets. Rising Treasury yields directly increase the risk-free rate, pressuring high-valuation assets like stocks. Major global equity indices are under pressure, with growth sectors like technology particularly hard hit. Concurrently, the UK 30-year gilt yield touched 5.81%, its highest level since 1998, and European bond markets faced simultaneous selling pressure.
From a yield curve structure perspective, long-end yields are rising faster than short-end yields. The spread between the 30-year and 5-year yields remains around 90 basis points, presenting a classic "bear steepening" pattern. This indicates the market is pricing two layers simultaneously: the short end reflects a reassessment of policy rates based on hike expectations, while the long end reflects the return of inflation persistence, increased debt supply, and fiscal credit risk premiums.
"The market's pricing logic has undergone a fundamental reversal: from narrowing rate cut expectations to outright hike panic," an analyst at Guosen Securities noted in a report. The interest rate futures market has completely priced out rate cuts for this year and has instead begun pricing in the probability of Fed rate hikes within 2026.
As the 10-year Treasury yield approaches the 4.5% "psychological line," Wall Street is embroiled in a fierce debate. Steven Barrow, Head of G10 Strategy at Standard Bank, predicts the 10-year yield will reach 5% this year—a forecast over 80 basis points higher than the Bloomberg strategist survey's year-end average. Barrow stated: "This view isn't driven by the war; it's just reinforced by it. The Fed is likely to keep policy too loose, and structural inflation pressures are rising." He cited a series of supply-side factors, including global supply chain bottlenecks, the ongoing impact of climate change, and restrictive immigration policies limiting labor supply.
However, for the 10-year yield to truly break above 5%, larger-scale selling is likely needed. For traders, this is a significant psychological threshold. Barrow himself conceded, "The fact that the market is currently holding at a 4.5% yield and we haven't seen a sustained move to 5% yet doesn't mean it won't happen."
In terms of bearish momentum, a J.P. Morgan client survey as of May 11th shows investor short positions have risen to their highest level in 13 weeks, indicating systematic accumulation of bearish sentiment. In the SOFR options market, traders are actively seeking to hedge against the risk of more rate hike expectations being priced in over the coming weeks.
Kelsey Berro, Fixed Income Portfolio Manager at J.P. Morgan Asset Management, pointed out: "The market has been very efficiently repricing the reality that higher energy prices will lead to inflation staying higher for longer."
As the global benchmark for asset pricing, every move in U.S. Treasury yields triggers the repricing of tens of trillions in global assets. Today, this anchor is swinging with unprecedented force. The historic reduction by Japanese investors is both a footnote to this macro shift and a key link in the transmission chain. With the 10-year yield approaching the critical 4.5% level, the 30-year having breached 5%, and the 2-year back near 4%, the market has clearly entered a new paradigm of high rates, high inflation, and high volatility.
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