The U.S. Treasury bond market has finally responded to the Mideast war, giving its assessment of the energy shock’s severity and the war’s effect on U.S. fiscal imbalance and inflation.
The past several days have marked a notable increase in bond market volatility and an increase in our fitted interest rate model to 4.45%.
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With the war approaching its one-month mark, one can see enhanced volatility in the bond market as well as a rising risk premium that investors are charging to purchase U.S. Treasury securities.
Investors’ concerns include an unsustainable American fiscal position, rising inflation risk and a growing uncertainty about war.
This is part of a wider move across asset markets as the war has moved from one of short-term disruption of energy supplies to longer-term structural damage to the regional production and refining capacity.
The MOVE index of volatility in the Treasury market is spiking above its 52-week average to levels consistent with past episodes of price instability and policy dysfunction.
This metric of bond market volatility is an instrument used to manage interest rate risk, and it is important to understand both as a practical risk measure and as an early warning sign of disruption to financial markets.
Sharp increases like those of the past several days are a reflection of increasing uncertainty.
If the uncertainty does not abate in the near term it could lead to a broader funding stress that will challenge credit markets that were already facing a problem inside the private credit market.
Large jumps like the one illustrated in the data visualization below often spill over into credit, currency and equity markets.
It is why we think equity markets are and will trade off rate markets the further we move into the crisis.
We can see this in the interest rate determination analysis from the Federal Reserve.
In the model developed by Tobias Adrian, Richard K. Crump and Emanuel Moench, the yield of a 10-year Treasury is equal to the sum of expectations for short-term interest rates and the term premium, which accounts for the risk of policy and economic disruptions over the life of the bond.
Since the inflation shocks of 2022-24, expectations of short-term interest rates had been in decline, following the easing of monetary policy by the Federal Reserve.
With the Fed on hold for now, the bond market’s concern over the impact of rising energy prices on inflation has intensified, causing expectations for short-term rates to increase.
The term premium is also increasing along with the rising uncertainty over fiscal policy and inflation.
The need for additional spending to finance the war would increase U.S. debt, sparking a bond market selloff as investors require additional compensation to cover potential losses.
Long-term rates such as 30-year mortgage rates are based in part on the benchmark U.S. 10-year yield.
Most important: The bond market remains undefeated.
The takeaway
Volatility in the Treasury market has spiked to levels consistent with past episodes of distress.
The threat of increased inflation and increased public debt has sent 2-year bond yields above 4.0% this week, while pushing 10-year yields above 4.4%.
Those moves are consistent with expectations for increased inflation and rising short-term interest rates and the potential of a bond market selloff that would accompany an increase in the issuance of U.S. debt.
