Investors have effectively priced in an end to the conflict in the Middle East well before any durable peace has been agreed upon.
Before the most recent tensions, that dynamic was observed in oil prices, easing yields and the ebbing of the risk premium across the U.S. Treasury curve over the past several weeks.
Oil prices have been in decline since May 18, when the price of Brent oil reached its last local peak at $112 per barrel before dropping toward $72 this week.
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The war had the benchmark 10-year Treasury yield moving higher but staying within its 4.0% to 4.5% trading range as U.S. troops were moved to the Mideast in January.
The 10-year broke above 4.5% for 10 trading days in May when it looked as if the war would continue, and then again in early June when it looked as if the Federal Reserve would respond to the increase in inflation.
As of July 7, the 10-year at 4.49% once more tested the top of its range as negotiations for a settlement dragged on and the headline inflation rate moved above 4%.
A Federal Reserve model of the determinants of 10-year Treasury yield has a fitted yield of 4.54%. This estimate is comprised of the sum of expectations of the short-term policy rate of 3.95% and a term premium of 0.59%.
That model suggests the Fed is looking through the immediate risk of inflation and that its policy rate will increase by only 30 basis points from the current effective federal funds rate of 3.65%.
The market, though, is adding another 59 basis points to account for the risk of the Fed having to respond more aggressively in the future.
The takeaway
The bond market appears to be looking through the threat of long-term inflation, pricing in just a bit more than a single Fed rate hike. It has held its risk premium for holding a long-term bond at 59 basis points.
As a result, the 10-year Treasury is trading at the top of the 4% to 5% range that has been in effect for the past three years.
While the Fed’s model of the 10-year suggests that the wartime increase in the risk premium is holding at current levels, we can expect sparse summertime trading to move the benchmark in unexpected ways.
