Escalating tensions in the Middle East are propping up oil prices, fueling expectations that the Federal Reserve may need to hike interest rates to curb inflation. This has triggered a sell-off in long-dated US Treasuries, and the shockwaves spread across global markets on Friday. The yield on the 30-year US Treasury rose 1 basis point to 5.38%, its highest level in nearly two decades, while the 10-year yield briefly surged to 4.97%.
Brent crude was trading just below $106 per barrel, roughly $2 off its earlier highs, with West Texas Intermediate holding above $101. Oil prices have jumped sharply following the seizure of Yemen's Mocha port by Iran-backed Houthi rebels. The group is now advancing toward the Bab el-Mandeb Strait, a critical waterway linking to the Red Sea and Suez Canal, which serves as a vital artery for global energy trade.
Where the market stands
According to Dai Hui, Chief Market Strategist for Asia-Pacific at JPMorgan Asset Management, Washington's control over the southern exit of the Red Sea is a deliberate move to pressure the global energy market and amplify the worldwide costs of the conflict. Ian Samson, a portfolio manager at Fidelity, noted that in the short term, all market movements are dominated by energy prices. Given the current situation and the potential for further restrictions on crude supply, there are legitimate reasons for the market to worry about oil prices climbing even higher.
Friday's trading extended the significant sell-off in long-term bonds seen on Thursday. In Asian markets, Japan's 10-year government bond yield rose 7 basis points to 2.98%, while the 30-year yield touched 4.05%. Investor anxiety was further exacerbated when US Treasury Secretary Scott Bessent's long-term debt buyback operation fell short of its target to repurchase $6 billion in bonds from the market, with the response underwhelming expectations.
Why just a handful of key factors?
Vincent Chung, a fixed income portfolio manager at T. Rowe Price, commented that the market was somewhat disappointed. Once expectations are set in the current environment, they essentially need to be exceeded, otherwise the market will punish accordingly. The combination of rising oil prices and high energy cost sensitivity in Asia has weighed on regional equities, with most markets posting losses. South Korea's KOSPI and Japan's Nikkei 225 each fell 2.6%, while Taiwan's Taiex declined 1.6%. Meanwhile, S&P 500 futures edged up 0.1%, and Euro Stoxx 600 futures saw a similar decline.
Fed rate hike probabilities, as priced by the futures market, have climbed to approximately 70%, up from 60% in early Thursday trading. Andrew Pease, Head of Asia-Pacific Investment at Russell Investments, stated that market expectations for the Fed's terminal rate have surged dramatically. The market is now essentially betting against the Fed, suggesting that policymakers are not prioritizing inflation enough.
Investors point to Friday's upcoming US inflation data for August as a critical determinant of whether the Fed will need to raise rates to contain price pressures. Richard Yetsenga, Chief Research Officer at ANZ, believes the Fed has already entered a rate-hiking phase. With the inflation target having been missed for five years, the unfortunate reality is that the Middle East conflict appears to be in a stalemate, keeping oil prices elevated.
Analysts suggest that Fed Chair Kevin Warsh's commitment to abandoning forward guidance has further fueled market panic. Dai Hui from JPMorgan noted that if the Fed reduces its policy guidance, investor concerns about the bond market will intensify. As uncertainty rises, the sell-off in Treasuries has diminished their appeal as a safe-haven asset. Samson from Fidelity explained that bonds were supposed to diversify portfolio risk, but now they are adding to it, making it unclear who will naturally step in as buyers for bonds in this environment.
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