Markets have adjusted quickly to the energy disruption tied to the Iran war, with investors increasingly pricing a firmer Federal Reserve reaction to inflationary pressures, according to analysts at BofA Securities.
In a note issued on Friday, strategists led by Aditya Bhave highlighted a pronounced change in how bond markets are behaving relative to oil futures since the conflict began in late February. From the start of the war until the Fed's meeting last week, the rate-sensitive 2-year Treasury yield and West Texas Intermediate crude futures traded "roughly in lockstep," the strategists said.
That relationship shifted in the sessions following the Fed gathering. Between that meeting and the end of trading in the U.S. on Thursday afternoon, the 2-year yield climbed by nearly 30 basis points, even as WTI edged down slightly, the note said.
The strategists interpret this decoupling as markets pricing in "a more hawkish Fed reaction function" after post-meeting remarks from Fed Chair Jerome Powell signaled officials were alert to the potential inflationary implications of the conflict. The assessment was reinforced, they added, by recent comments from Fed Governor Christopher Waller, who in an interview "sound[ed] very concerned" about the jump in oil prices tied to the fighting in the Middle East.
BofA's team noted that disruptions extend beyond crude to other commodities such as natural gas, fertilizers and helium, and that markets may be bracing for a broader commodity shock that would likely feed into core inflation.
The analysts also pointed out that the energy shock has effectively wiped out earlier market bets that the Fed would cut rates this year. Instead, traders have begun placing wagers that policymakers could lift borrowing costs in the months ahead.
Market action on Friday illustrated the uncertainty: WTI last rose by 3.7% to $98.01 a barrel, while the 2-year Treasury yield slipped slightly by 2 basis points to 3.963%. Traders were also parsing recent developments in U.S.-Iran tensions, including President Donald Trump's decision to extend until April 6 a deadline for Iran to reopen the Strait of Hormuz or face U.S. aerial strikes.
In a Truth Social post, the president said the extension was requested by the Iranian government and that Tehran was engaged in "ongoing" talks with the United States that are "going very well," adding that media reports suggesting otherwise were "erroneous."
Last weekend, Trump issued an ultimatum threatening to strike Iranian power plants if Tehran did not unblock the Strait of Hormuz, a critical chokepoint through which about one-fifth of the world's oil flows. He later said he would not carry out such strikes until Friday after what he described as "very strong" discussions with Iran. Tehran has publicly denied that negotiations with Washington are taking place.
Adding to the picture of economic risk, an OECD report published on Thursday warned that the war is darkening the global outlook. The report singled out the danger that an energy price shock could trigger a surge in inflationary pressures that would weigh on overall growth.
Summary
BofA strategists say markets are re-pricing the Fed toward a more hawkish stance following an energy shock tied to the Iran war. A recent divergence between the 2-year Treasury yield and WTI crude futures, along with officials' comments and commodity disruptions, has eliminated expectations for rate cuts this year and introduced the possibility of near-term rate increases.
Key points
- Energy shock from the Iran war has altered market expectations for U.S. interest-rate policy, reducing bets on rate cuts and creating room for potential hikes.
- The 2-year Treasury yield moved roughly in lockstep with WTI from the start of the conflict through last week's Fed meeting; it rose nearly 30 basis points after the meeting even as WTI dipped slightly.
- Disruptions to natural gas, fertilizers and helium raise the risk of a broader commodity shock that could feed into core inflation, influencing both fixed income and commodity markets.
Risks and uncertainties
- Higher energy prices could spark a broader commodity shock, which would likely pass through into core inflation and affect inflation-sensitive sectors.
- Market repricing toward a more hawkish Fed increases volatility in bond markets and could tighten financial conditions, with potential knock-on effects for growth-sensitive sectors.
- Escalation or miscommunication around the Strait of Hormuz deadline and related diplomatic developments could further move oil prices and market expectations, adding uncertainty to both commodity and interest-rate markets.