Why didn’t bonds catch this one?
Oil shocks usually send money into bonds. This one pushed bond prices down instead. The reason doesn’t look like inflation. It looks like the price of money.
On Wednesday the 10-year US Treasury yield touched 5.11%, its highest since 2007. Brent crude sat just above $100. Diesel hit a record $6.52 a gallon. And on the same day the S&P 500 fell.
That combination should bother anyone with a balanced portfolio. The whole point of owning government bonds next to stocks is that when something frightening happens, the bonds go up while the stocks go down. War in the Gulf is about as frightening as markets get. The bonds went down anyway.
Meanwhile the stock market is roughly 1% below its record, and the market’s fear gauge, the VIX, is near 15, which is calm. So the scary part isn’t showing up in stocks. It’s showing up in the thing that was supposed to protect them.
What I want to do is take the bond yield apart, see which piece moved, and follow that piece to where it leads. I’ll tell you now that it doesn’t lead where most headlines say it does.
- OfficialStraight from the source: the Federal Reserve, the Bureau of Labor Statistics, the Treasury, the Energy Department, the IMF.
- DerivedArithmetic I did on official inputs, and only as good as they are. The equity sensitivities, the reserve take-up rates.
- JudgmentMy call. The three paths out of this and the odds I put on them.
- ClaimedSaid on the record by a party with a stake, and not independently checked. Chiefly the US military’s figures on Iranian oil exports.
The splitTwo numbers hiding inside one.
A 10-year bond yield is really two things added together. One is the real yield: what you earn after inflation. The other is the market’s guess at inflation over the next ten years, which traders call the breakeven. You can see both separately because the Treasury also sells inflation-protected bonds, and the gap between the two kinds of bond is the inflation guess.
So I pulled the Federal Reserve’s daily figures for the last trading day before the strikes on Iran, 27 February, and for 22 September, the latest official print.
The yield rose by about a full point. 0.91 of it came from the real yield. The inflation guess moved 0.08, and at 2.33% it is still inside the band it has sat in since late 2022.
Read that again, because it is the opposite of the headline. An oil shock is an inflation story, so you would expect the inflation piece to jump. It barely twitched. The bond market isn’t pricing inflation getting away. Something else is doing the work.
The inflation fear barely moved. The price of money did.
The FedA central bank that won’t look away.
Consumer prices were up 3.4% on the year in August. Energy alone was up 16.3%, and by my arithmetic on the government’s own weights it accounts for about one point of that 3.4. Core inflation, which leaves out food and energy, was 2.4%. Take the oil out and the picture is close to what the Fed had been comfortable with.
Central banks have a textbook answer to a supply shock like this: look through it. Oil spikes, oil fades, and raising rates in the meantime only slows the economy for no lasting gain. The Fed didn’t take the textbook answer. On 16 September it raised rates to 3.75–4.00%, unanimously, and a week later Governor Michael Barr said that “further policy adjustments are likely to be needed.” Markets now put roughly 70% odds on another hike in October.
That fits the piece that moved. When the Fed signals it will keep tightening into a shock rather than wait for it to pass, the real yield is what you would expect to rise. On this reading, you aren’t being paid more to fear inflation. You’re being paid more because money itself got more expensive.
The cushionWhy both halves fell together.
Every investment is, underneath, a stream of future cash divided by a rate. A bond’s cash is fixed coupons. A company’s cash is future profits. The rate that divides them is, at bottom, the real yield.
Most market scares hit the top of that fraction. A recession threatens profits, so stocks fall, and investors rush into bonds, which pushes bond prices up. That is the cushion working. This time the pressure is on the bottom of the fraction. Raise the divisor and everything is worth less at once: the bond and the stock, together.
How much less? Here is a deliberately crude check. The S&P 500 closed at 7,706 on Wednesday, and analysts expect about $397 of earnings per share over the next year. Hold those earnings flat and push the real rate up, point for point:
A one-point rise in real rates is worth about 16% off the index on that arithmetic, and about 25% if profits slip at the same time. It is too simple to use as a forecast. What it shows is the direction and the scale, and that the bonds sitting next to those stocks are exposed to the same divisor.
There is a recent precedent. In 2022, when real yields climbed from well below zero, US stocks and the broad US bond market both had losing years, and the balanced portfolio had one of its worst years on record. That was a rate shock too.
Bonds cushion growth scares. They’ve struggled when money itself gets more expensive.
The oilWhy hasn’t the shock faded?
A Fed can afford to be patient with a shock that is clearly on its way out. This one isn’t. The US has run a naval blockade of Iranian ports since April, lifted briefly in June and reimposed in July. The IMF’s satellite ship tracker counted one vessel crossing the Strait of Hormuz on 20 September, against about 85 a day in the year before the war. The admiral in charge says Iran has exported “zero barrels”. That is his claim, and Iranian officials dispute it, but the tanker counts point the same way.
And the President has said, at the United Nations, that he expects a deal “right after the election.” Tehran heard that too.
Which brings me to the question I actually started with: did Washington empty the emergency oil reserve to keep pump prices down before the midterms?
The Strategic Petroleum Reserve is at 284.6 million barrels, its lowest since 1982 and about 131 million below March. That part of the story is true. But almost none of those barrels were sold. They were lent. Oil companies borrow them now and must hand back more later, about a quarter more on the Energy Department’s own figures. And the reserve can only lend what companies choose to borrow.
Look at June. The department offered 40 million barrels and companies took half a million. Bids closed three days after a new ceasefire, when oil for delivery now was no longer pricier than oil for later. Borrowing a barrel today and returning a barrel plus a premium next year only makes sense when today’s barrel is the expensive one. When that stopped being true, the borrowing stopped.
On this evidence, the reserve followed the futures market, not the polling calendar. There hasn’t been a new offer since. Near-dated oil is pricier than later-dated oil again now, so a new offer would probably find takers. Whether the department makes one before 3 November is worth watching, because that is where a political motive would show up.
After NovemberThree roads, and the election picks the lanes.
From here I see three paths to the end of next March. A grinding stalemate is the likeliest, at 45%: oil stays around $90 to $110 and the 10-year holds around 5 to 5.5%. A deal after the election comes next, at 35%: oil drifts back toward $75 to $85, real yields ease, and bonds start doing their job again. Escalation is least likely, at 20%, and the one that matters most: oil at $120 to $150, and the stock market down 15 to 25% with little help from bonds.
Weight them together and the S&P 500 ends about 4% lower. But the average hides the shape. Stocks are near a record, so the upside is modest, and the downside is not.
Timing matters too. If the President’s own words are a guide, almost none of the deal odds sit before 3 November. After it, the result shapes the tail more than the middle:
| If this happens on 3 November | Betting markets | Deal | Stalemate | Escalation |
|---|---|---|---|---|
| Democrats take both chambers | 63% | 38% | 50% | 12% |
| Democratic House, Republican Senate | 29% | 30% | 52% | 18% |
| Republicans hold both | 8% | 25% | 45% | 30% |
| Weighted, if still at a stalemate on election day | ≈35% | ≈50% | ≈15% |
A Democratic Congress brings war-powers votes and funding fights, which make escalation harder and a deal more attractive. A Republican hold does the opposite for the tail. I don’t lean on betting markets for the war itself: in June they had a peace deal at 97%, a few weeks before it fell apart.
The other sideWhat the calm crowd has right.
Now the good arguments against me, because there are real ones.
The shock is still priced as temporary. That flat inflation line in the first chart cuts both ways. If the market thought this oil was here for good, inflation expectations would be climbing. They aren’t. So if oil eases, real yields have room to fall fast, and bonds would go straight back to being a cushion. That is the deal path, and it is not a long shot.
Profits are doing the heavy lifting. S&P 500 earnings grew about 33% last quarter, and the index trades at roughly 19 times next year’s earnings. That isn’t cheap, but it isn’t 1999 either. Strong earnings are exactly what lets stocks absorb a higher discount rate.
The Fed can change its mind. It is tightening because it fears the shock will leak into everything else. If core inflation stays near 2.4% and the jobs market softens, the case for more hikes weakens, and the real yield with it.
None of that makes the cushion work today. It does mean the hole in it could close quickly, and that selling everything on a bond chart would be its own kind of mistake.
Five tellsWhat to actually watch.
The 10-year breakeven is at 2.33%. If it breaks above 2.6%, the market has started fearing inflation itself, and this becomes a different, worse story.
It’s at 2.63%. A move back under 2.3% would say the rate shock is fading, and bonds would start cushioning stocks again.
The IMF tracker publishes daily. A seven-day average above 40 a day for four straight weeks would be the deal path showing up in the water before it shows up in a statement.
The Energy Department still has about 38.5 million barrels of authorised lending unused. An offer in October is where a political motive, if there is one, would finally be visible.
September’s price data lands mid-October. Core above 2.6% would mean energy is leaking into everything else, which is exactly what the Fed is afraid of.
The cushion didn’t break. It just isn’t built for this kind of shock.
Bonds protect a portfolio against the economy getting weaker. What is happening now is money getting more expensive, because a central bank has decided not to wait for an oil shock to pass, and a war that is being timed around an election is keeping that shock alive.
That can end well and quickly. A deal, easing oil and a Fed that relaxes would put the cushion back where you left it. But for now, and until one of the tells above moves, the thing most people own for safety can end up as a second bet on the same rate as everything else.
You can read the bond market today. Washington hasn’t voted yet.
The receiptWhat’s real, what’s noise, and what we still don’t know.
What’s real
- The 10-year is up about a point since the war began, and 0.91 of it is real yield.
- Inflation expectations are 2.33%, inside their range since late 2022.
- The Fed hiked on 16 September and signalled more.
- Hormuz traffic is a fraction of normal on the IMF’s own count.
- The oil reserve is at its lowest since 1982.
What’s noise
- “Bonds are pricing runaway inflation.” The inflation piece of the yield barely moved.
- “The reserve was drained to win the midterms.” The evidence says it was lent, and borrowing stopped when the futures market turned.
- “Iran exports zero barrels.” A claim by one side of a war, disputed by the other.
- “Stocks are calm, so it’s fine.” Calm stocks near a record are the setup, not the reassurance.
What we still don’t know
- Whether the Fed hikes again in October.
- Whether the Energy Department reopens the reserve before the vote.
- Who controls Congress, and what that does to the war’s tail.
- Why the tanker count and the military’s escort figures don’t match. Ships sailing with their trackers off would explain it; nobody has shown it.