What bond markets say about the oil shock

Brent crude crossed $100 after the Hormuz shock, and the Treasury market split in two. Five-year and ten-year inflation breakevens shot up, while real yields fell across the curve. Taken apart, the pricing tells a clean and unhappy story.

Reading the two halves of a yield

A nominal Treasury yield can be split into a real yield and compensation for expected inflation. The Treasury has sold inflation-protected securities, known as TIPS, since 1997; their principal rises with the consumer price index, so their yield is a real yield. The difference between a nominal bond and a TIPS of the same maturity, the breakeven, is the inflation rate at which the two would earn the same return. When breakevens rise and real yields fall at the same time, investors are saying they expect more inflation and weaker growth together.

Breakevens up, real yields down

Breakevens, the gap between nominal Treasuries and TIPS, widened by more than 40 basis points in two weeks. Investors were pricing in dearer fuel, freight and manufacturing inputs, and they did it fast. Real yields went the other way. Fund managers expect hundred-dollar oil to choke off demand and squeeze corporate margins, and they bought protection against a weaker economy accordingly.

Short-dated breakevens have always tracked energy closely, because the consumer price index that TIPS are linked to includes petrol, and petrol prices follow crude within days. A five-year breakeven is therefore partly a bet on where fuel prices will be over the life of the bond. The ten-year measure is less sensitive to oil, which makes its move the more worrying of the two: investors are extending their inflation fears beyond the immediate shock.

The fall in real yields has its own logic. Real yields reflect expected growth and the real return investors demand, and a supply shock that cuts incomes lowers both. Money moving into TIPS for inflation protection also pushes their prices up and yields down. Some of the move may reflect that demand rather than a pure change in the outlook, but the direction is consistent with a market bracing for slower growth.

Bonds stop working as a hedge

For a balanced portfolio this is about the worst combination on offer. Rising nominal yields hand bondholders losses on duration, and equity multiples shrink as investors brace for consumers to pull back and margins to erode. The usual offset between the two asset classes has gone missing.

The offset depends on the type of shock. For most of the two decades before 2021, the main risk to markets was weak demand, which pushed stocks and bond yields down together, so bonds rose in price when equities fell. Inflation shocks break that pattern, because they push yields up and hurt equities at the same time. In 2022, when inflation surged, the broad American bond market had its worst year on record and stocks also fell sharply, and investors who held the traditional mix of sixty per cent equities and forty per cent bonds lost on both sides.

The Fed reads these numbers closely. Market-based inflation expectations are one of the few real-time gauges of whether the public still believes in the 2 per cent target, and officials have repeatedly said that well-anchored expectations are what allow them to look through supply shocks. A sharp rise in short breakevens is expected in an oil shock. A sustained rise in long ones would tell the committee that its credibility is being questioned, and would push it towards tightening regardless of growth.

Credit markets add a third signal. Corporate bond spreads, the extra yield companies pay over Treasuries, usually widen when investors fear slower growth, and they widen most for firms in energy-intensive industries. If spreads widen while breakevens rise, the market is pricing stagflation in earnest; if they stay calm, investors still expect the shock to pass without a recession.

Who gains, who loses

Holders of TIPS and of commodities are the obvious winners, along with trend-following funds that can go short bonds and long oil. Energy producers' shares hedge part of the damage for equity investors. The losers are balanced funds and pension schemes that rely on bonds to cushion equity falls, risk-parity funds that hold leveraged bond positions to balance their risk, and savers in conventional long bonds whose real returns shrink as inflation rises. Companies planning to issue long-term debt face higher nominal borrowing costs even as their growth prospects dim.

Why the signal may be overstated

The strongest counterargument is that breakevens overshoot in energy shocks. They rose sharply in the first half of 2022 and fell back later that year as oil retreated, and the inflation-protected market is smaller and less liquid than the nominal one, which can exaggerate moves when investors rush into it. Falling real yields also help equity valuations, because future profits are discounted at a lower rate, so the damage to stocks may be smaller than the breakeven signal implies. The Fed may yet see the shock as temporary and hold steady, which would limit the rise in nominal yields.

That argument has weight for the short end. It is harder to make for the ten-year breakeven, which prices a decade of inflation rather than a year of fuel bills. If long-term inflation compensation stays elevated after oil stabilises, the market will be telling the Fed that its credibility is being tested.

What to watch

The five-year, five-year forward inflation rate, which strips out the next five years to show where investors expect inflation to settle, is the best gauge of whether the shock is spreading. Demand at the next TIPS auctions will show how much investors will pay for protection. The correlation between daily stock and bond returns shows whether bonds have regained their role as a hedge, and every update on tanker traffic through Hormuz will move all three. The bond market is treating the Hormuz crisis as a stagflationary tax. Unless the strait reopens soon, holders of balanced funds should expect both halves of their portfolio to lose purchasing power, and real returns to stay low for some time.