How war in Iran is disrupting what bond markets expected from the Fed

The Treasury Department is holding several government bond auctions this week. It’s selling some short-term debt, along with 5- and 7-year Treasury notes. 

Treasury auctions can tell us a lot about the interest rates investors are demanding to be paid, which in turn can tell us about what investors expect the economy to do in the future.

Bond markets were pretty calm a month ago. Guy LeBas, chief fixed income strategist at Janney Montgomery Scott, said the expectation was that rates would trend lower.

“The underlying theme was that even if economic growth and the jobs markets remained stable-ish, inflation would fall enough to permit the Fed to cut,” LeBas said.

But then, the president’s war in Iran started. Energy prices spiked.

“Central banks are concerned that another inflation shock, even if it’s just caused by a temporary spike in oil, might convince consumers and businesses that inflation is going to be high for a long time,” LeBas said.

Now, investors are expecting that the Fed will hold rates steady this year. There’s even a small chance that the Fed could hike rates.

“If there’s strong enough demand for those higher energy prices, and people keep paying for energy, and also are buying other things, then you can really have stronger inflation more broadly, and that’s when the Fed would want to act,” said Luke Tilley, chief economist at Wilmington Trust.

But Tilley said what’s more likely is that those higher energy prices will cause consumers to cut back, especially since the labor market has been slowing down.

“And if the spike in energy prices pulls away from people’s spending on other things, then it’s more likely that we get a slowdown in growth,” he said.

Tilley said that means the Fed could go back to cutting rates by the end of the year.