The inflation-driven spike in the market premium for the US 10-year yield in 2022-2023 has been gradually reversing over the last several years. But in the wake of the turmoil in the Middle East, which has raised energy costs and inflation, the pre-war calculus may be set for an attitude adjustment.
The Treasury market’s reaction to the war has been muted so far. The benchmark rate shot up to nearly 4.50% in late-March, but has pulled back to close at 4.34%. A rise above the previous high would signal that the bond market is pricing in higher inflation risk.
The Capital Spectator’s ensemble model currently estimates fair value for the 10-year yield at roughly 4.0%, based on monthly analytics through March. That reflects a mostly steady fair-value calculation in recent months.
A market premium over fair value has prevailed in recent years. During the height of the 2022-2023 inflation shock, the premium spiked to well over a full percentage point. Investor sentiment has been gradually unwinding that premium, but the Middle East turmoil and the potential for unleashing higher inflation for an unknown period going forward will likely raise the premium again.
The offsetting factor is the potential for slower growth. The energy-supply shock threatens to elevate inflation and reduce economic growth, which is disinflationary. It’s unclear if one or the other side of this macro equation will dominate.
It’s possible that each risk offsets the other, leaving the yield premium relatively steady and near equilibrium. My guess is that the market will initially favor a higher premium driven by risk, followed by a lesser premium as sentiment pivots to the potential for slower growth later in the year.
The greater clarity on what lies ahead is that the news flow from the Middle East will continue to dictate market sentiment. On that score, the crowd has yet another challenging trading week ahead in the wake of failed peace talks between the US and Iran over the weekend, followed by President Trump’s announcement that the US Navy will ‘interdict’ ships that pay Iran to pass through the Strait of Hormuz. In response, Iran threatened to attack Gulf ports in retaliation against a blockade.
Surprisingly, a fragile ceasefire is holding, as of early Monday. Regional mediators are racing to close remaining gaps between the US and Iran as the ceasefire deadline nears, even as President Trump weighs renewed military pressure if diplomacy stalls.
“The volume of ships passing the Strait needs to surge in the coming two weeks for the oil market to be convinced that the crisis is over,” said Malcolm Melville, a commodities fund manager at Schroders. “If the vessel number surges to 75% of prewar levels, then that represents a near normalization of flows, given the current use of pipelines that were not previously running at full capacity.”
What passes for “normal” these days, however, isn’t showing up on anyone’s bingo card this morning.