News of a temporary agreement between the United States and Iran to reopen the Strait of Hormuz has triggered a broad rally in global bond markets. Traders have subsequently scaled back their bets on Federal Reserve interest rate hikes for this year, as Brent crude oil prices continue to decline, cooling inflation expectations.
Swap market data indicates the probability of a 25-basis-point Fed rate hike by December has fallen to around 70%, down from approximately 80% last Friday. U.S. Treasury yields fell across the curve, with the most policy-sensitive short end leading the decline. The 2-year yield fell as much as 7 basis points to 4.01%, while the 10-year yield dropped 6 basis points to 4.42%.
The decline in oil prices directly alleviated market concerns about further inflationary pressures. The drop in U.S. Treasury yields also rippled through other market segments, including corporate bonds and emerging market assets. European and Asian bond markets saw concurrent rallies, while the U.S. dollar's decline is directly linked to a reduction in safe-haven demand.
Fabio Bassi, head of cross-asset strategy at JPMorgan, noted that investors believe lower oil prices will reduce the need for developed market central banks to adopt more aggressive rate hikes. However, market participants have grown accustomed to the volatile news flow from the Middle East and thus maintain a degree of skepticism about the current situation.
Yields Fall Across the Curve, Pressuring Short Positions
The decline in U.S. Treasury yields was evident across all maturities. The 2-year yield fell as much as 7 basis points to 4.01%, while the 30-year yield dropped 5 basis points to 4.92%, reaching its lowest level since May 7th.
Tomo Kinoshita, a global market strategist at Invesco Asset Management Japan, pointed out that based on historical correlations observed post-conflict, a 10% drop in oil prices corresponds to roughly a 13-basis-point decline in the U.S. 10-year Treasury yield.
Matthew Haupt, a portfolio manager at the hedge fund Wilson Asset Management, stated that some short positions in interest rate products will likely be unwound. Central banks can now afford to be less hawkish as they can wait and look past any short-term inflation spikes.
In Europe, bond yields also broadly declined as traders similarly pared back their expectations for rate hikes from the Bank of England, which meets this Thursday, and the European Central Bank. The ECB last week became the first major central bank to cut borrowing costs, reducing them by 25 basis points.
Fed Decision Looms, Easing Pressure on Wash
The Federal Reserve is set to announce its policy decision this Wednesday, marking the first interest rate meeting chaired by the new Chair, Wash.
Economists expect the Federal Open Market Committee to hold the benchmark interest rate steady in the 3.5%-3.75% range, while it assesses the actual economic impact of the energy price shock stemming from the Iran conflict. Previously, U.S. consumer price growth hit its fastest pace in three years, fueling a rise in support for a rate hike within the FOMC.
Leslie Falconio, head of taxable fixed income strategy at UBS Global Wealth Management, said the decline in oil prices is alleviating the pressure on Wash to raise rates.
She noted that before the ceasefire news, the 2-year yield was still rising as the market priced in a near-100% probability of a hike by December 2026. With oil prices falling, the market is stripping out those rate hike expectations, leading to the decline in short-end yields.
Falconio expects the FOMC to formally remove its easing bias at this week's meeting, signaling a more hawkish forward guidance. However, she also stated she still anticipates the Fed's next move will be a rate cut, likely in the first or second quarter of 2027.
She said that holding rates steady will allow policymakers to assess the state of economic growth, which is "still just about holding on," and the subsequent direction of the labor market. She believes they will exercise their option to wait and see, letting the data come in before making changes.
Divergent Interpretations of Agreement, Market Enters Anxious Wait
Despite the generally positive market sentiment, uncertainty surrounding the implementation of the agreement cannot be ignored. There are significant differences in statements from the U.S. and Iran regarding Strait transit fees, highlighting the difficulty of reaching a final agreement on unresolved issues related to Iran's nuclear program.
Andrew Ticehurst, a strategist at Nomura Holdings, stated that the Strait is expected to reopen on Friday, so there may be an anxious waiting period from now until then. Actions by Israel during this period could also be a variable.
Regarding the U.S. dollar, the Bloomberg Dollar Spot Index fell to its lowest level since June 5th, driven by reduced safe-haven demand. However, since the U.S. and Israeli strikes on Iran in late February, the index is still up about 1.4% cumulatively, and traders maintained an overall positive stance on the dollar last week.
Looking ahead, Fabio Bassi expects the U.S. 10-year Treasury yield to be near 4.70% by year-end and believes that if yields rise above that level, it would present a buying opportunity for long-term investors.
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