Oil prices break through the $90 mark! Iran's conflict ignites inflation concerns, traders flock to TIPS for hedging

Financial Express APP learns that the international crude oil futures settlement price has broken through the $90 mark, reaching a new high since October 2023. WTI crude oil and Brent crude oil each recorded their largest weekly gains since 1983 and 1991, respectively. WTI crude oil futures for April closed up 12.21%, at $90.9 per barrel; this week’s increase is 35.6%. Brent crude oil futures for May rose 8.52%, to $92.69 per barrel, with a weekly gain of 27.88%. Due to energy prices soaring amid the Middle East conflict, investors have flooded into the U.S. bond market, purchasing inflation-resistant products, pushing some bonds to their highest valuations in nearly a year.

In the U.S. Treasury and inflation swap markets, investors can receive payments linked to the Consumer Price Index (CPI). However, since the weekend attacks by the U.S. and Israel on Iran and Iran’s retaliatory actions, along with soaring oil prices, the costs of these payments have also surged.

The demand for short-term inflation-protected bonds (TIPS) has been supported by hedging against rising prices, with their yields increasing less than traditional bonds. Currently, the yield on the 5-year U.S. Treasury note is about 3.7%, compared to approximately 1.05% for 5-year TIPS, reaching the highest level since April. This yield spread can serve as a reference for the average expected inflation rate over the next five years.

Jon Hill, Head of U.S. Inflation Strategy at Barclays Capital, said, “In the current environment, TIPS are very attractive because their cash flows increase with the Consumer Price Index (CPI). We also know that rising energy prices will eventually push up gasoline prices, which in turn will raise the CPI.”

On Friday, the economic outlook faced more complexity. The unexpectedly weak U.S. February non-farm payroll data caused U.S. Treasury yields to decline for the first time this week. Meanwhile, benchmark U.S. crude oil futures prices rose to their highest level since 2023. The demand for protection is also evident in inflation swaps, with hedging costs soaring. The one-year CPI swap rate is close to 2.9%, up from about 2.5% a week ago.

Gang Hu, Managing Partner at Winshore Capital Partners, said that short-term TIPS enjoy the prospect of higher inflation-adjusted interest payments and are almost certain that the Federal Reserve will not raise interest rates due to the short-term inflation shock caused by rising oil prices.

Hu stated, “Short-term inflation pressures will be very high. Meanwhile, short-term real interest rates should decline because the Fed is unlikely to raise rates due to inflation shocks.”

Although rising oil prices have dampened expectations of the Fed easing monetary policy this year, traders still believe at least one rate cut is likely. Rising oil prices have pushed up the national average retail gasoline price in the U.S., with a 3.32% increase on March 5, while the price on March 1 was just below $3.00. In January, gasoline prices accounted for 2.9% of the U.S. Consumer Price Index.

Omair Sharif, President of Inflation Insights LLC, said that short-term inflation expectations for consumers are “largely driven by gasoline prices because gasoline prices are very visible, and most people see changes in gasoline prices weekly.” Sharif also noted that rapid fluctuations like the Russia-Ukraine war in 2022 can also influence long-term inflation expectations.

The U.S. government plans to release the February CPI report next week, which is expected to show a year-over-year increase of 2.4%, unchanged from January. Since mid-2023, inflation has generally remained below 4%, after peaking at 9.1% in 2022.

Phoebe White, U.S. Inflation Strategist at JPMorgan, said, “Based on the latest rise in oil prices, the risk distribution of oil price movements may have increased significantly today, which will provide more support for TIPS.”

She added that investor positioning is also a factor, as market inflation expectations declined in February due to concerns over disruptive risks from artificial intelligence and worries about private credit.

This week, the strength of TIPS was mainly concentrated in short-term bonds. The breakeven inflation rate for the 30-year U.S. TIPS is about 2.22%, close to its lowest range in the past year. Hu explained that one reason is that, in the long run, rising oil prices could lead to deflation because increased gasoline expenditure suppresses consumption of all other goods.

Additionally, slowing U.S. economic growth has led to reduced tax revenues, while increased military spending may widen the U.S. budget deficit, requiring more borrowing, which puts pressure on bond prices. Hu stated, “Long-term fiscal conditions during wartime are always worse. This will push up long-term interest rates—both nominal and real.”