Global markets were already roiled by growing caution around AI-related trades and signs of stress in European government bonds. Moody’s decision not to downgrade France last Friday will likely provide only temporary relief for OATs, given that the negative watch remains in place. As cracks emerge in the risk-on narrative, investors have sought safety in US Treasuries, Bunds and JGBs.
However, the rise in Brent crude above USD 116/bbl bears watching. The move reflects fears of another round of US-Iran escalation ahead of the US midterm elections in early November. Oil prices are now approaching the high of just above USD 120/bbl recorded in late April. Although softer crack spreads offer some relief, an extended period of elevated oil prices will likely affect both inflation and inflation expectations. Notably, after declining through 2Q, the 2Y breakeven has steadily moved higher and is now trading at around 2.6%.
From a macro perspective, this presents a dilemma for US yields. Heightened downside risks to growth argue for lower yields, while sticky inflation—even if driven by energy prices—should keep Fed hike expectations resilient. Curve flattening in the 2Y/10Y and 5Y/30Y segments may be one way to express this view. Alternatively, receiving the 2Y/5Y/10Y fly could also work.
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