To The Moon

Rising concerns over a potential escalation of conflict in the Middle East have driven international oil prices sharply higher, fueling worries that global inflationary pressures could intensify once again, according to reports. U.S. Treasuries came under selling pressure on Wednesday, with yields across maturities broadly climbing and shorter-dated notes seeing particularly pronounced increases. At the same time, the U.S. dollar strengthened, reflecting that investors are reassessing the potential impact of geopolitical risks on inflation and Federal Reserve monetary policy.

During Wednesday's trading session, the U.S. Treasury market was relatively calm for most of the day, but around 2:45 p.m. New York time, the market suddenly saw noticeable volatility. At that point, U.S. West Texas Intermediate crude oil futures quickly rose from about $97 per barrel to near $98.50, pushing Treasury yields to their intraday highs. The two-year U.S. Treasury yield briefly rose 5 basis points to 4.83%, the highest level in a week. Since bond prices move inversely to yields, the rapid rise in yields means investors are selling U.S. Treasuries. Meanwhile, major U.S. stock indexes also briefly fell, while the dollar strengthened.

The market volatility was mainly driven by a report concerning the Middle East situation. According to the report, the United States was preparing to order the evacuation of some embassy staff stationed in the Persian Gulf region. Because the United States launched a military conflict with Iran in February this year, the news quickly triggered concerns about another escalation in the region. However, as U.S. officials later clarified that the evacuation order involved only Saudi Arabia, market tensions eased somewhat, and part of the initial price swings triggered by the news also faded.

John Briggs, head of U.S. rates strategy at Natixis North America, said Iran-related risks have in fact never completely disappeared. If the market becomes worried again about an escalation of conflict, global bond yields could face upward pressure once more, because higher energy prices would raise inflation risks and could prompt investors to further raise their expectations for central bank policy rates.

In fact, since the outbreak of the Middle East war in February this year, international oil prices have continued to rise, already reigniting global inflationary pressures and prompting the Federal Reserve and other major central banks to raise interest rates. For the bond market, the impact of higher oil prices is especially complex. On the one hand, geopolitical risks usually drive investors to buy safe-haven assets such as U.S. Treasuries. On the other hand, if energy prices continue to rise and intensify inflation, the market may expect central banks to adopt a more restrictive monetary policy, thereby pushing Treasury yields higher. At present, the latter factor is clearly weighing on the U.S. Treasury market.

U.S. Treasury yields remain near multi-year highs touched earlier this month. Previously, expectations for strong U.S. economic performance, continued growth in government debt, and further Fed rate hikes had jointly pushed Treasury yields higher. With international oil prices rising again, investors have become more cautious in their assessment of the Fed's monetary policy outlook. The Federal Reserve will announce its next interest rate decision on October 28, and officials have now entered the routine quiet period before the policy meeting. Based on interest rate market pricing, traders estimate the probability of a Fed rate hike at this meeting at about 20%. Although this probability has not yet become the market's mainstream expectation, Middle East tensions and changes in energy prices could still influence investors' judgment of the future rate path.

Meanwhile, the U.S. Treasury market is also facing pressure from new debt issuance. In Wednesday's auction of 20-year U.S. Treasuries, the winning yield reached the highest level for comparable auctions since the U.S. Treasury resumed issuing that maturity in May 2020, highlighting that current long-term financing costs remain elevated.

In addition to inflation and debt supply factors, U.S. stock market performance is also affecting Treasury market moves. U.S. stocks rose on Wednesday, briefly weakening investors' safe-haven demand for Treasuries and further pushing yields higher. However, after news about the Middle East situation emerged, the stock rally was briefly dented.

It is worth noting that the relationship between the U.S. stock market and bond market has also changed recently. Over the past two weeks, share prices of U.S.-listed companies related to artificial intelligence infrastructure capital spending have fallen sharply, raising concerns about whether massive AI investment can continue to generate sufficient profits. At the same time, some investors have begun to worry that U.S. economic growth may slow, so even as international oil prices continue to rise, some funds are still flowing into U.S. Treasuries in search of safety. This flow of funds shows that the bond market is currently being pulled by multiple factors. On the one hand, higher energy prices, inflation pressure, and expectations of Fed rate hikes are weighing on bond prices. On the other hand, a correction in technology stocks and the risk of an economic slowdown may stimulate safe-haven demand.

Overall, the Middle East situation has once again become an important variable affecting global financial markets. As international oil prices approach the upper end of their trading range since February this year, investors will closely watch whether the conflict further escalates and whether higher energy prices will prompt the Federal Reserve to maintain a more restrictive monetary policy stance. Before the Fed's October 28 rate decision, oil price movements, geopolitical news, and the market's repricing of the inflation outlook are expected to remain important factors affecting U.S. Treasury yields and the dollar's performance.