Global markets witnessed a wave of risk repricing this week, after developments in the oil market coincided with rising government bond yields, bringing inflation fears and monetary policy tightening back to the forefront of the investment scene.
While investors initially anticipated a clearer path for interest rates, a surge in energy prices and growing concerns about supplies in the Middle East led to a rapid shift in market expectations, pushing US Treasury yields to levels not seen in years.
The yield on the benchmark 10-year US Treasury note reached approximately 5.22% during the week, its highest level since 2007, before retreating slightly as oil prices declined. The yield on the benchmark 30-year Treasury note also rose to around 5.53%, its highest level since 2004.
Oil sparks fears
Oil was one of the key drivers of market shifts during the week. Prices rose by about 3% in one session following a Houthi missile attack on Saudi Arabia, renewing concerns about disruptions to energy supplies in the region.
If Brent crude remains above $100 a barrel for an extended period, inflationary pressures are not only coming from higher fuel costs, but are extending to transportation, industry, services, and supply chains, making the task of central banks more difficult.
But the picture has changed partly with the emergence of signs of US-Iranian talks on a phased path to ending the war and reopening the Strait of Hormuz, which has helped oil prices retreat from their highs and given bond markets some calm.
Herein lies the sensitivity of the markets: any improvement in oil flows or the prospect of the strait reopening could ease inflation and yield pressures, while renewed unrest could quickly reignite them.
Bonds at the heart of the storm
The rise in US Treasury yields was not merely a reflection of oil price movements, but rather the result of a combination of factors occurring simultaneously.
In addition to rising energy prices, US economic activity data showed greater strength than expected, and the price components of the activity indices also rose, reinforcing concerns that inflation may remain high for a longer period.
Meanwhile, the U.S. Treasury market has faced relatively weak demand in some debt auctions, coinciding with the government's continued funding needs and increased corporate issuance, including by technology companies funding a massive expansion in AI-related spending.
These factors combined have raised the return that investors demand to hold long-term bonds, especially with growing concern about the trajectory of US debt and fiscal deficits.
Why do bond yields matter to all markets?
The importance of the 10-year US Treasury yield lies in its role as a key benchmark for asset pricing worldwide. When the yield on a relatively low-risk asset rises, stocks, real estate, private credit, and emerging markets must offer higher returns to remain attractive to investors.
The high cost of borrowing is also quickly passed on to the real economy through mortgages, auto loans, consumer credit and corporate finance.
US mortgage rates have risen to around 7% as bond yields have climbed, adding pressure to the housing market and increasing financing costs for households and businesses.
The Federal Reserve faces a more complex equation.
What is important for the markets is that the rise in oil prices does not happen in a vacuum; if higher energy prices lead to increased inflation, the Federal Reserve may be forced to keep interest rates high for a longer period or raise them again.
Indeed, market bets on a US interest rate hike in October have risen to around 71% following economic activity data and rising energy prices, compared to around 53% before the release of the strong activity data.
This means that investors are no longer just dealing with the question of when the Fed will cut interest rates, but another question has come to the fore: Does the Fed need to raise rates further to combat inflation?
This shift is extremely important because it changes the cost of capital and affects stock valuations, especially growth and technology stocks that rely heavily on expectations of future earnings.
Stocks are holding up... but under pressure from returns
Despite the turmoil in the bond market, global stocks have not yet entered a widespread sell-off, as the strength of technology stocks and continued interest in artificial intelligence have helped to support stock indices.
Global stocks are on track for their best weekly performance since early August, buoyed by optimism about the artificial intelligence sector, along with hopes for improved energy supplies in the Middle East.
But the continued rise in returns represents a crucial test of this rally. As the risk-free return increases, the opportunity cost of investing in stocks rises, and the present value of companies' expected earnings declines, putting further pressure on growth stocks.
Conversely, some energy-related sectors may benefit from higher oil prices, while energy-intensive sectors and companies more reliant on borrowing will face greater pressure.
The dollar benefits from rising yields.
The change in interest rate expectations was also reflected in the currency market, with the dollar hitting a two-month high during the week, supported by rising Treasury yields and increasing expectations of a US interest rate hike.
A rising dollar has mixed effects on the global economy; it may support dollar-denominated assets and increase the attractiveness of US debt instruments, but at the same time it raises the cost of servicing dollar-denominated debt for emerging markets, and makes dollar-denominated commodities more expensive for buyers outside the United States.
