Traders in the US Treasury market have rapidly scaled back their bets on Federal Reserve interest rate cuts this year, due to the strategic importance of the Strait of Hormuz for global oil shipments. However, the real threat facing bond investors is long-term inflation expectations, which may struggle to remain anchored around 2% unless supply disruptions are resolved.
There are indications that the US Treasury market is already shifting toward a higher interest rate environment. After five consecutive years of inflation exceeding target levels, investors are demanding higher real yields. Core inflation had already surpassed 3% even before oil prices breached $100 per barrel, suggesting real yields could climb further.
If inflation expectations become unanchored, they could become a powerful channel driving interest rates upward. From this perspective, following supply chain disruptions from the COVID-19 pandemic and price surges triggered by massive stimulus measures, Federal Reserve policymakers demonstrated considerable skill in communication management. Although they were slow to raise rates, the magnitude of increases proved sufficient to successfully contain inflation expectations, which have remained within a historically narrow range since 2021.
The standoff in the Strait of Hormuz could alter this outlook. If supply disruptions persist, an oil price shock would need to be substantial enough to force demand reduction, thereby pushing prices down again. Meanwhile, prolonged supply interruptions would further increase costs and reinforce expectations of rising inflation.
Initial market signals on Friday indicated that investors had not positioned for extended supply disruptions. Renewed concerns about oil shocks impacting economic growth partly reignited expectations for rate cuts in the second half of 2026 and 2027. Additionally, the 5-year breakeven inflation rate showed no clear upward trend.
However, later in the day, yields began to rise alongside climbing oil prices. Furthermore, the experience during pandemic-era supply chain disruptions demonstrates that investors eventually respond more forcefully. In 2022, breakeven inflation rates reached their highest levels since 2014, compelling the Fed to raise rates to curb market expectations of further oil price increases.
The risks are greater this time. In 2022, the Fed was already vigilant about inflation and likely to respond aggressively. Now, the Fed leans toward easing policy, with new leadership expected amid repeated calls for rate cuts from President Donald Trump. In response to the Iran war situation, Trump has intensified pressure, urging immediate Fed rate reductions.
If supply disruptions continue, the risk of surging inflation expectations could outweigh growth concerns, potentially catalyzing a shift toward a more sustained higher yield environment in the US Treasury market.
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