The oil price breaks through the $90 mark! The Iran conflict ignites inflation concerns, traders flock to TIPS for hedging.

The settlement price of international crude oil futures has exceeded the $90 mark, reaching a new high since October 2023. WTI crude oil and Brent crude oil have recorded their biggest weekly gains since 1983 and 1991 respectively. WTI crude oil futures for April contract closed up 12.21% at $90.9 per barrel, rising 35.6% for the week. Brent crude oil futures for May contract rose 8.52% to $92.69 per barrel, up 27.88% for the week. As the Middle East conflict caused energy prices to soar, investors flocked to the US bond market to purchase products that can hedge against inflation, leading to some bond valuations reaching the highest levels in nearly a year. In the US Treasury and inflation swap market, investors can receive payments linked to the US Consumer Price Index, but since the US and Israel attacked Iran over the weekend and Iran retaliated, the cost of these payments has also risen along with the soaring oil prices. The pressure of hedging against price increases has supported the demand for Treasury Inflation-Protected Securities (TIPS), whose yield increases are lower than traditional bonds. Currently, the yield on 5-year US Treasury bonds is around 3.7%, reaching its highest level since April compared to five-year TIPS (yield around 1.05%). This yield difference can serve as a reference for the future expected average inflation rate over the next five years. Jon Hill, head of US inflation strategy at Barclays Capital, said, In the current situation, TIPS are very attractive because their cash flow increases with the rise of the Consumer Price Index (CPI). And we know that rising energy prices will eventually push up gasoline prices, thereby raising CPI. On Friday, investors faced a more complicated economic situation. Unexpectedly weak US nonfarm payroll data for February led to a decline in US Treasury yields for the first time this week. Meanwhile, the price of US benchmark crude oil futures contracts rose to the highest level since 2023. The demand for protection is evident in the inflation swap, with hedging costs for inflation soaring. The implied rate for a one-year swap is close to 2.9%, compared to around 2.5% a week ago. Gang Hu, managing partner at Winshore Capital Partners, said that TIPS enjoy higher interest payment prospects adjusted for inflation in the short term, and it is almost certain that the Federal Reserve will not raise rates due to temporary inflationary shocks caused by rising oil prices. Hu said, Short-term inflation pressure will be very high. At the same time, short-term real interest rates should decrease because the Fed may not raise rates due to inflation shocks. Although expectations for the Fed to loosen monetary policy this year have decreased with the rise in oil prices, traders still believe there will be at least one rate cut. The rise in oil prices has pushed up the average national retail gasoline price in the US, with an increase of about 3.32% on March 5, while the price on March 1 was just below $3. Gasoline prices accounted for 2.9% of the US Consumer Price Index in January. Omair Sharif, president of Inflation Insights LLC, said that short-term inflation expectations for consumers are largely driven by gasoline prices, as gasoline prices are very visible, and most people see changes in gasoline prices regularly. Sharif also said that rapid fluctuations like those seen in the 2022 Russia-Ukraine war can also affect long-term inflation expectations. The US government plans to release the CPI report for February next week, expected to show a 2.4% year-on-year increase, unchanged from January. Since mid-2023, the overall inflation rate has been below 4%, peaking at 9.1% in 2022. Phoebe White, head of US inflation strategy at JPMorgan, said, With the latest rise in oil prices, the risk distribution of oil price trends may have increased significantly today, providing more support for TIPS. She said that investor positioning is also a factor, as inflation expectations in the market have decreased in February due to concerns about disruptive risks posed by artificial intelligence and concerns about private credit. The strength of TIPS this week is mainly concentrated in short-term bonds. The breakeven inflation rate for US 30-year TIPS is around 2.22%, close to the low range over the past year. Hu said that one reason is that in the long run, rising oil prices may lead to deflation because increased spending on gasoline will dampen consumption of all other goods. In addition, slowing US economic growth has led to reduced tax revenues, increased military spending, and could widen the US budget deficit, requiring increased borrowing, putting pressure on bond prices. Hu said, The long-term fiscal situation during wartime is always worse. This will raise long-term interest ratesboth nominal rates and real rates.