Rising oil prices weaken the Fed's interest rate cut expectations, pushing US bond yields to their highest level this month.

As oil prices continue to rise, weakening market expectations of a rate cut, US Treasury bonds faced selling pressure on Wednesday, pushing yields to the highest level this month. Traders even began betting that the next policy action by the Federal Reserve may not be a rate cut, but a rate hike. Ahead of the Fed's rate decision announcement at 2 am Beijing time, the market widely expected rates to remain unchanged. Traders have almost completely abandoned their bets on rate cuts for the year and instead are factoring in the possibility of a rate hike by the central bank in the first half of 2027. Yields on US bonds across different maturities rose by 4 to 6 basis points, with the most interest rate-sensitive short-term bonds leading the rally. The yield on the two-year US bond rose by 6 basis points, approaching 3.90%, reaching its highest level since March 27; while the yield on the 30-year US bond approached 5%, reaching its highest level since July. Yields in the European bond market also rose in sync. Priya Misra, portfolio manager at Morgan Asset Management, stated that the market is coming to terms with a possibility that oil prices may stay high for a longer period, not only increasing the risk of inflation, but also pushing up long-term inflation expectations and making Fed decisions more complex. Analysts pointed out that since the end of February, when the US launched attacks on Iran, causing oil prices to rise, energy prices have continued to climb, driving up gasoline costs and fueling inflation expectations. This has weakened the market's previous expectations for a rate cut path. Prior to the outbreak of the Iran conflict, traders had fully priced in rate cut expectations, but now this logic is being reevaluated. Interest rate derivative markets are also reflecting this change. Short-term rate contracts linked to Fed policy rate expectations show that the December 2026 contract rate has risen to about 3.62%, hardly reflecting any room for rate cuts. On the other hand, contract rates expiring in the first half of 2027 have risen by at least 5 basis points and are higher than the current effective federal funds rate of 3.64%, implying that the market is starting to factor in the probability of rate hikes. Fund flows also indicate that investors are building new bets, indicating that the next policy action by the Fed may be a rate hike, and not a rate cut. Market participants believe that this shift reflects a new logic in the interest rate market, where oil prices and inflation risks are now the main drivers. If the risk of disruptions in the Strait of Hormuz persists, keeping energy prices high, the Fed may need to keep rates high for even longer.