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In the markets for Treasuries and inflation swaps, where investors can receive payments linked to the US consumer price index (CPI), the cost of those payments has soared with oil since the United States and Israel attacked Iran over the weekend, and as Iran has retaliated.
The appetite to hedge against hotter price pressures has supported short-term Treasury Inflation-Protected Securities (TIPS), yields on which have risen less than those on conventional bonds.
The result is that the yield on regular five-year notes, at about 3.7%, is now around the highest since April relative to the rate on five-year TIPS, which yield 1.05%.
That gap is a market proxy for the average expected inflation rate over the coming half-decade.
“TIPS are a very attractive product at moments like this because the literal cash flows increase alongside CPI inflation,” said Jon Hill, head of US inflation strategy at Barclays Capital.
“And we know that a pickup in energy prices is going to feed through to higher petrol and therefore higher CPI.”
Last Friday, the economic backdrop grew even more complex for investors.
A report showing surprisingly weak February employment pushed yields on regular Treasuries lower for the first day last week. The US benchmark oil futures contract rose to the highest since 2023.
The quest for protection is also evident in inflation swaps, where the cost of receiving inflation has soared. For a one-year CPI swap, the exchange rate is near 2.9%. A week ago it was about 2.5%.
Short-maturity TIPS enjoy both the prospect of bigger inflation-adjusted interest payments and the near-certainty that the US Federal Reserve (Fed) won’t raise interest rates in response to a brief inflation shock stemming from costlier oil, said Gang Hu, managing partner at Winshore Capital Partners.
“The short-term inflationary pressure is going to be very high,” Hu said. At the same time, “short-term real rates should go down because the Fed is probably not going to hike with the inflation shock.”
While expectations for Fed easing this year have declined with the rise in oil prices, traders still see at least one move.
The advance in oil prices has jacked up the US national average retail price of petrol, to about 3.32% on March 5 from just under US$3 on March 1. Petrol accounted for 2.9% of the US CPI in January.
For consumers, short-term inflation expectations are “largely driven by petrol prices, just because they are so salient and most people see them on a pretty regular, weekly basis,” said Omair Sharif, president of Inflation Insights LLC.
Rapid moves such as the one caused by Russia’s invasion of Ukraine in 2022 can influence longer-term expectations as well, Sharif said.
The government is scheduled to release the February CPI report this week. It’s expected to show a year-on-year increase of 2.4%, unchanged from January. Inflation broadly has been below 4% since mid-2023, after peaking at 9.1% in 2022.
“The risk distribution of where oil prices can go has likely shifted materially higher today” based on their latest increases, “driving more support for TIPS,” said Phoebe White, head of US inflation strategy at JPMorgan Chase & Co.
Investor positioning is also a factor, as market-based inflation expectations fell in February amid worries around the disruptive risk of artificial intelligence and concerns around private credit, she said. — Bloomberg
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