The US Treasury market is facing a fresh wave of selling, as surging oil prices and escalating Middle East tensions push inflation risks back to the forefront for investors. Long-term yields have broken through critical technical levels, with real interest rates climbing to their highest point since 2008.
On Tuesday, the yield on the benchmark 10-year US Treasury note rose to 4.64%, marking a near two-month high and breaching the closely watched 4.60% technical level, and it continues to trade around 4.63%. The 30-year yield also moved higher, with yields across the curve generally rising by 2 to 5 basis points. Concurrently, the US dollar strengthened against most major currencies.
Analysts point to the immediate catalyst for this sell-off: Brent crude oil prices rising to around $91 per barrel. With the US and Iran engaging in strikes against each other for a tenth consecutive day and Houthi militants in Yemen continuing to threaten Red Sea shipping lanes, volatile energy prices are once again driving up inflation expectations.
Futures markets tied to the Federal Reserve's policy rate indicate traders currently assign roughly a 25% probability of an interest rate hike at next week's policy meeting. While this probability has decreased from near-even odds earlier in the month, rate hike bets have quietly crept higher over recent days as Middle East conflicts persist.
Notably, this bond market sell-off has completely erased the gains triggered by last week's lower-than-expected inflation data, underscoring a swift and cautionary reversal in market sentiment.
Oil Prices as the Primary Driver, Technical Breaks Amplify Moves
Izaac Brook, a rates strategist at RBC Capital Markets, noted that "today's market move is primarily a direct reflection of the continued rise in energy prices."
He also emphasized that the yield moves were amplified by the breach of key technical levels—the 2-year yield reclaimed ground above 4.20%, and the 10-year broke through 4.60%. This, combined with typically thinner summer trading conditions, has exacerbated volatility.
From a market structure perspective, shrinking trading volumes have also contributed to the swings. According to CME Group open interest data, Monday's trading volume for Secured Overnight Financing Rate (SOFR) futures and options was only 74% and 54% of their 20-day averages, respectively. This below-normal liquidity makes prices more sensitive to directional shocks, allowing one-sided moves to be magnified.
Furthermore, the decline in long-term bonds is not solely driven by inflation expectations; the persistent rise in real interest rates is also a significant factor. On Tuesday, the yield on the 30-year Treasury Inflation-Protected Security (TIPS)—a proxy for real rates—climbed to 2.95%, its highest level since 2008.
Elevated real rates reflect robust market expectations for economic growth, rising capital costs, and expanding funding demands fueled by persistent government deficits and the investment boom in artificial intelligence.
Analysis suggests this structural pressure implies that even if inflation data softens temporarily, long-term rates are unlikely to retreat easily.
Uncertainty Clouds the Federal Reserve's Policy Path
Regarding the Federal Reserve's policy outlook, significant market divergence remains. Christopher Hodge, Chief US Economist at Natixis, stated:
"As we are seeing, with energy prices being volatile, the Fed should be led by realized data, not just forecasts for where headline CPI is going."
He added, "Under the new leadership, the Fed's reaction function is far from clear."
This commentary highlights the core dilemma facing markets: on one hand, inflationary pressure from oil price shocks is real and persistent; on the other hand, the policy direction of the Fed under its new leadership remains opaque, making it difficult for investors to form stable expectations for the interest rate path.
The outcome of the Federal Reserve's policy meeting next week will serve as a crucial test for whether current market pricing is justified.
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