Editor's Note: On September 1st, global markets faced dual pressures: escalating US-Iran tensions drove international oil prices higher rapidly, while sovereign bond sell-offs persisted, with Japan's 10-year government bond yields hitting 3% for the first time in 30 years. US stocks, gold, and Bitcoin all simultaneously declined as the US dollar and Treasury yields rose.

More critical than asset price movements is the shift in market expectations for inflation and interest rates due to the energy shock. Weak job vacancies, construction spending, and manufacturing data initially pointed to an economic slowdown, but the rise in oil, diesel, and natural gas prices could elevate overall inflation. This presents a more complex challenge for the Fed: slowing growth amidst lingering price pressures.

Author Tyler Durden interprets this market phase as a return to a 「stagflation trade.」 The core thesis is that energy prices, rate markets, and risk assets have become intertwined in pricing; a sustained surge in oil prices could further constrain the Fed's policy space, with long-term Treasuries facing pressure from inflation, fiscal deficits, and AI financing demands.

It should be noted that the continuity of energy prices in core inflation and whether the Fed will continue raising rates in the face of weakening employment still hold considerable uncertainty. Option markets pricing in tail risks for rates have notably heated up, reflecting investor hedging against extreme scenarios rather than a definitive shift to an accelerated rate hike phase.

Below is the translated excerpt of the original article:

After the US retaliated against Iranian targets, international oil prices surged rapidly, intensifying the global bond sell-off. Stocks, gold, and crypto assets all came under pressure, with market concerns over stagflation and further rate hikes becoming more pronounced.

The US economic data released on that day was not robust: job vacancies, construction spending, manufacturing PMI, and Dallas Fed service sector indicators all signaled varying degrees of cooling. However, simultaneously, oil prices, refined product prices, and bond yields all rose, while the interest rate futures market also increased the odds of a September Fed rate hike.

This combination forms the central contradiction under focus in this article: economic activity is softening, yet an energy supply shock may rekindle inflation. If price pressures persist, the Fed will find it challenging to solely rely on employment and growth data to pivot to easing; however, continuing rate hikes in a weakening economy could magnify pressures on both financial markets and the real economy.

Crude Oil Breaks $90, Real Pressure Comes from Refined Products

After the U.S. launched a new round of attacks on Iran, the market began to reassess the possibility of prolonged disruption in energy transit through the Strait of Hormuz. U.S. crude oil futures briefly rose above $90 per barrel, hitting a new high since late July.

Shortly after, the Islamic Revolutionary Guard Corps of Iran warned that the U.S. would face "severe punishment." The U.S. continues to pressure Iran through military actions and sanctions. The duration of the conflict, Iran's retaliatory measures, and whether maritime security further deteriorates have become the key variables for short-term pricing in the oil market.

U.S. Treasury Secretary Benson downplayed the long-term strategic value of the Strait of Hormuz. He stated that Gulf nations are accelerating the construction of onshore oil pipelines, and in two years, oil transport may bypass the strait. However, this statement describes future alternative transportation capacity and does not eliminate current supply and shipping risks.

Looking at the spot market, while spot Brent crude oil prices have risen, they remain broadly within recent volatility ranges. Rich Privorotsky, head of Goldman Sachs' Delta One trading desk, believes that the market faces pressure not only from oil prices but more significantly from the signals released by the refined products and natural gas markets.

European natural gas prices have risen to about a three-and-a-half-year high, heating oil is close to recent peaks, and the U.S. diesel crack spread has hit a record. The crack spread measures the price difference between refined products and the cost of crude oil, usually reflecting the tightness in the refining sector's supply and demand balance.

This means that even if crude oil prices do not sustainably break out of the recent range, consumers may still face higher prices for diesel, heating oil, and other fuels. Lower crude oil prices may also not directly translate into lower end-user prices; some of the price differentials may convert into higher refining margins.

Privorotsky assesses that if refined product prices remain at current levels, overall inflation in the coming months may once again face upward pressure. Whether the energy price hike will eventually spill over into core inflation remains a key decision-making factor: a one-off supply shock may not necessarily alter the medium-term inflation trend, but if transportation, production, and service costs continue to rise, price pressures may gradually transmit to other sectors.

According to the original source of market data, since February, the global finished oil wholesale price has increased by an average of around $40 per barrel, with diesel contributing to over 40% of the increase. During the same period, global finished oil exports have decreased by approximately 6 million barrels per day year-on-year, with the Persian Gulf region and Russia accounting for three-quarters of the decline. Since this data is from exchange analysis, it should be seen as the statistical criterion of the relevant institution rather than official unified data.

Oil Price Rebinds with Interest Rates, Stagflation Trading Returns

Privorotsky believes that it is difficult to separate the energy market from the rate market in the short term. The rise in oil prices and finished oil may elevate inflation expectations, leading investors to demand higher bond yields; the increase in yields will in turn depress the valuation of risk assets such as stocks.

This trading relationship was particularly evident on September 1. U.S. Treasury bond yields rose across the board, with a greater increase in the short end, leading to a "bear market flattening" of the yield curve.

The so-called bear market flattening refers to a general decline in bond prices, an overall increase in yields, and a situation where short-end yield rises faster than the long end, flattening the yield curve. This usually signifies that the market has raised expectations of near-term rate hikes or continued policy tightening.

On that day, as oil prices rose and manufacturing surveys continued to show price pressures, the market's bet on a September rate hike by the Federal Reserve significantly increased. The original text stated that the related probability briefly exceeded 70% during the intraday session; other public market indicators showed that the probability of a rate hike at that time was around 65% to 70%. Different data may come from different sampling points and contract calculation methods, so they should not be forcibly unified.

This pricing round was also influenced by remarks from Federal Reserve Chairman Kevin Warsh. The rise in oil prices was not the sole reason for the heightened rate hike expectations; more accurately, the energy shock reinforced inflation concerns already present in the market.

The author summarizes the current environment as a typical stagflation scenario: weakening growth and employment data alongside rising energy costs. The related "stagflation asset portfolio" has performed relatively well recently, reflecting that some investors are positioning themselves for a slowdown in growth and an increase in sticky inflation.

However, whether the rise in oil prices will alter Fed decisions still depends on the duration and transmission to core prices. If energy prices quickly fall back, the policy impact may be relatively limited; if diesel, natural gas, and transportation costs remain persistently high, the risk of inflation spreading again will significantly increase.

Global Bonds Under Pressure as Treasury Buybacks Fail to Offset Supply Surge

Prior to the energy shock, the global bond market was already in a sell-off. On September 1, the global sovereign bond composite yield rose to near 2008 highs, while the Japanese 10-year government bond yield touched 3%, a first since 1996.

Japanese government bonds were particularly affected by a combination of inflation, fiscal expansion, and expectations of further Bank of Japan rate hikes. Yields on US, German, and UK government bonds also rose, indicating this was not a localized market fluctuation.

The longer end of the US government bond market faced additional pressure. The original text pointed out that the 30-year Treasury bond yield rose in early trading, temporarily erasing the decline seen after the Treasury announced an expansion of long-term bond liquidity support through buybacks.

The US Treasury had previously announced that it would increase the size of one-off liquidity support buybacks for 10- to 30-year bonds from a maximum of $20 billion to at least $40 billion, with the new arrangement set to take effect on September 9. Buybacks can improve the liquidity of older securities and market trading conditions but do not directly reduce the US Treasury's net financing needs and are not equivalent to Fed quantitative easing.

Priya Misra, Portfolio Manager at Morgan Asset Management, believes that Treasury buybacks may provide some demand for long-term bonds but could be overshadowed by financing supply due to AI infrastructure development. Here, "AI supply pressure" mainly refers to large tech companies, utilities, and data center operators issuing debt to build computing power, electricity, and supporting facilities.

Meanwhile, ongoing US fiscal deficits, continued government borrowing, and a new round of corporate bond issuance are all increasing the supply of long-duration assets. John Briggs, Head of US Rates Strategy at Natixis North America, argues that until welfare spending reforms truly alter the fiscal deficit outlook, long-end yields may continue to remain elevated; in his view, Treasury buybacks remain merely a "drop in the bucket" compared to overall bond supply.

This is also the difference between the current long-end rate pressure and mere rate hike expectations. The short end mainly reflects the Fed's policy path, while the long end has to digest inflation risks, fiscal deficits, term premiums, and bond supply. Even if the Fed does not continue hiking rates, long-end yields may not necessarily quickly retreat.

Rate Tail Risk Heats Up, Options Market Wary of "Negative Convexity"

While the spot bond market is slowly declining, some investors are heavily buying deep out-of-the-money payer swaptions, betting on a significant future rate hike.

Nomura Securities strategist Charlie McElligott pointed out that there has been a significant increase in demand for mid-term maturity, high strike payer swaptions, with some of the demand coming from a large buyer who is not a typical participant. These trades have driven up the payer skew, making options purchased for rate hike protection more expensive compared to rate drop options.

However, the overall volatility of rate payer swaptions has not increased significantly in line with the rise in yields. This is because the bond market currently resembles a continuous, slow sell-off rather than a short-term violent sell-off. The actual volatility is low, yet investors continue to buy extreme upside protection, leading to a mismatch between the spot movement and the tail risk pricing.

The risk lies in the fact that if rates shift from a slow rise to a rapid increase, market makers may need to concentrate hedging on previously sold deep out-of-the-money options. Since the market may not have enough counterparties to provide offsetting positions, this type of hedging could further amplify rate volatility, creating a so-called "negative convexity" moment.

Negative convexity refers to the scenario where, following a rate change, some market participants are forced to increase hedges in the direction of the market movement: the more rates rise, the more they need to increase their long rate positions, potentially driving rates even higher. The current options demand indicates that investors are guarding against this risk, but it does not mean that this scenario is inevitable.

Going forward, the market needs to observe three sets of variables: whether the US-Iran conflict and the situation in the Strait of Hormuz continue to impact energy supply; whether prices of end-use energy such as diesel and natural gas can sustain and pass through to core inflation; and the extent of weakening in job data, enough to deter the Fed from further tightening.

If energy prices remain high, inflation expectations continue to rise, and bond supply pressure does not ease, the outlined stagflation and rate tail risk logic will be reinforced. Conversely, if energy supply resumes, fuel differentials shrink, or a significant deterioration in employment forces the Fed to prioritize growth risks, the foundation of this rate increase trade could weaken.

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