After the Hamas attack, the rush to safety faded fast

Hamas's horrific attack on Israel on 7 October at first sent trading desks to the usual script for a geopolitical shock. Investors piled into havens, bidding up gold, crude oil and US Treasuries. Within forty-eight hours the bond rally had gone and long-term Treasury yields were climbing again. The threat of a wider war in the Middle East could not outweigh the glut of Treasuries on offer.

How the shock was priced

The attack came on a Saturday, so markets had a weekend to absorb it. When trading resumed, oil prices jumped on fears that the conflict could draw in Iran and threaten supplies from the Gulf, and gold rose as it usually does in a crisis. The American cash bond market was shut on Monday for the Columbus Day holiday, so the first move in Treasuries came through futures, which pointed to lower yields. By the time the cash market reopened the haven bid had faded.

Israel itself is not a large oil producer, so the direct effect on supply is small. The market is pricing the risk of escalation: a conflict involving Iran, a threat to shipping through the Strait of Hormuz, or a response from Saudi Arabia and its partners in OPEC+, who have already been restricting output this year. Those tail risks lift oil and gold, and in the past they would have pulled Treasury yields down with them.

Treasuries lose their shelter

Geopolitical shocks used to offer a reliable hedge, pushing yields down as investors sought shelter in government bonds. Now the US Treasury is selling vast amounts of debt to fund very large deficits, and investors are unwilling to hold more long-dated paper even in an emergency. The weight of supply has overwhelmed the brief rush to safety.

The supply problem was visible well before the attack. The ten-year yield rose from under 4 per cent in the spring to its highest since 2007 last week, driven by heavier auctions, the Fed's continuing reduction of its bond holdings and the retreat of price-insensitive buyers such as foreign central banks. Fitch's downgrade of American debt in August and the chaotic funding fight in Congress have added to the unease. A haven that is being issued faster than investors want to buy it offers only partial shelter.

Oil complicates the hedge

There is a second reason the rally faded. A war that pushes up oil prices also pushes up inflation, and higher inflation is bad for bonds. In 2022 the invasion of Ukraine lifted energy prices and helped drive the worst year for Treasuries in decades. When the shock itself is inflationary, bonds can fall at the very moment a hedge is most needed, and investors have learned that lesson recently.

The precedent that matters most is fifty years old. The Yom Kippur war began on 6 October 1973, and the Arab oil embargo that followed quadrupled the price of crude within months, feeding the inflation of the 1970s that wrecked bond portfolios for a decade. Today's oil market is far less exposed: America is now the world's largest producer, and energy takes a smaller share of household budgets. The risk of a supply shock is much reduced, but it is not zero if the war spreads.

Who holds the risk

The losers from this shift are the investors who built portfolios on the assumption that bonds rise when stocks fall. The traditional mix of 60 per cent equities and 40 per cent bonds relied on that negative correlation, and for most of the two decades before 2022 it held. When yields rise on supply fears even during a crisis, both halves of the portfolio can fall together, as they did last year. Pension funds and balanced funds are left looking for protection elsewhere.

The beneficiaries are the alternatives. Gold, which pays no interest but cannot be issued by a finance ministry, has regained some of its appeal as a crisis hedge. Short-dated Treasury bills, which carry little duration risk and yield above 5 per cent, offer safety without exposure to the long end. The dollar also tends to strengthen in a crisis, benefiting holders of cash more than holders of long bonds.

The Federal Reserve is watching the same move. Several officials said this week that the climb in long-term yields has tightened financial conditions and could reduce the need for a further rise in the policy rate. Markets took that as a sign that the Fed sees supply-driven yields doing some of its work, which helps holders of short-dated bills more than owners of long bonds.

Where the old rule may return

The counterargument is that the hedge still works when the shock is big enough. A war that spread across the region and pushed the world economy into recession would drag yields down sharply, whatever the deficit, as it did in 2008 and in the early days of the pandemic. The failure of the rally so far may say more about the market's judgement that the conflict will stay contained than about the death of Treasuries as a haven.

That caveat is fair, and it points to what to watch: signs of Iranian involvement, the price of Brent crude, and the reception of the Treasury's next long-dated auctions. Its refunding announcement in early November will show whether supply is set to keep rising.

If a war in the Middle East cannot hold Treasury yields down for more than two days, investors should stop counting on long bonds as a hedge for as long as the deficits stay this large. Balanced portfolios will keep carrying that exposure until the Treasury shows it can shrink its long-dated issuance, and nothing in the current budget fight suggests that will happen this year.