The Bond Market Listens To Adjectives And Ignores Barrels

Why did the front end move 14 basis points for a speech about inflation and nothing for the oil shock that causes it?

Here is what happened, in order. On Friday morning Kevin Warsh told Jackson Hole the Fed has work to do, put the preferred inflation gauge at 3.7% over 12 months and 4.1% over 6, and declined to rule out a September increase. By the close, September hike odds had moved from 35.4% to 57.5% and the 2-year had gone from 4.20% to 4.34%. Fourteen basis points. The largest single-session move in that series in weeks.

Then over the weekend, US forces struck 2 Iranian launchers on Larak Island that were preparing to mine the Strait of Hormuz, Tehran’s Guards hit 2 US air bases in Jordan, and Brent for November rose 5.70% to 91.03 dollars. On Monday the 10-year printed 4.716%, roughly 0.6 of a basis point lower than Friday.

Walking the dots

The Friday move is easy to read. The dollar confirmed it, gaining 0.52% to 99.68, its best day in about a month. The curve flattened, front end faster than long, which is textbook: policy expectations rose without a matching rise in long-run inflation compensation. Equities lost a quarter of a point and bitcoin lost 3.01%, both of which are what you would expect from an asset class that had priced the cutting cycle.

Monday is the puzzle. Oil is not a sideshow to inflation, it is one of its main inputs. Hormuz carried roughly a fifth of seaborne crude before February. A 5.70% move in the global benchmark on live ordnance, three days after a central banker said prices were his predominant focus, is the sort of thing that should push a rate-sensitive curve somewhere.

What the textbook expects, and what happened instead

The textbook says an energy supply shock raises headline inflation, and a central bank that has just declared inflation its priority is therefore more likely to tighten, so the front end should rise. Alternatively, the textbook says an energy shock is a tax on growth, so the front end should fall on weaker demand. Both are respectable. What the textbook does not offer is nothing at all.

There are three honest readings. The market may believe 91 dollars is already fully absorbed and the disruption is priced. It may believe this Fed will look through imported energy inflation, whatever the chairman says about prices. Or it may simply not be pricing the war at all any more, 7 months in, because the disruption has become a level rather than an event. The third is the least flattering and, on the volatility evidence, the most likely: the fear gauge closed lower on the day hike odds doubled.

Phil’s Musing

My honest lean is the third one. We have had 7 months of this, and somewhere along the way the market stopped treating Hormuz as news and started treating it as weather. That is usually the point at which something in the Gulf goes properly wrong and everyone acts surprised. I am not adjusting the Weathervane on it, because the turn condition I wrote in advance was that the long end follows crude through a genuine supply event, and it plainly did not. But I want the record to show that the banner survived this week on a technicality rather than on evidence.