iFlow > Short Thoughts
Published on Tuesdays, Short Thoughts offers perspectives on US funding markets, short-term Treasuries, bank reserves and deposits, and the Federal Reserve's policy and facilities.
John Velis
Time to Read: 4 minutes
EXHIBIT #1: SHORT-TERM AND LONG-TERM INFLATION EXPECTATIONS
Source: BNY Markets, Bloomberg
EXHIBIT #2: CROSS-BORDER INVESTORS AVOID USTS
Source: BNY Markets, iFlow
The conflict in the Middle East has unsurprisingly led to higher oil prices, a stronger U.S. dollar and risk-asset volatility. Less expected, however, has been the rise in global yields, particularly in markets that are normally considered safe havens in times of geopolitical stress. U.S. yields are a glaring example, rising around 20bp from their levels on Friday, February 27, the day before hostilities began. We looked at this topic last week, after just one business day of trading during the conflict.
At the time, we argued that higher oil prices pushed yields higher by lifting inflation expectations. A quick decomposition using current (as of this writing) levels shows the 10y breakeven inflation rate (TIPS, or the difference between nominal bond yields and the inflation-linked security of the same maturity) has risen just over 10bp, while the 10y TIPS yield is up a little more than 8bp. The latter move indicates marginally higher real yields over time, probably reflecting muted expectations of higher interest rates in response to rising oil prices. Indeed, the December 26 OIS market shows that investors expect just 38bp of tightening for the remainder of the year, compared to around 61bp priced in just before the conflict started.
In Exhibit #1, we show the 10y breakeven inflation rate and the 1y inflation swap. The former, which measures annual average inflation expectations over the next decade, is still very close to the range in which it has been trading for several years, roughly between 2.2% and 2.5%. Its move higher due to higher oil prices has been modest and does not indicate a breakout in long-term inflation expectations. The shorter-term measure, with a 1y horizon, has moved much more, from around 2.5% before the conflict began to nearly 3%. This 0.5% increase is materially higher but remains well contained – certainly below levels seen in the months after last April’s tariff announcements.
Obviously, the length and intensity of the conflict will determine how high crude prices go and how long they stay elevated. For now, with developed economies already facing sticky inflation, the path of inflation expectations will be key for bond yields. We understand why bonds haven’t rallied but note that with the U.S. 10y yield now trading between 4.10% and 4.20%, it remains below levels seen in early 2025 and in late January, when yields touched nearly 4.3%.
iFlow shows similar behavior among investors and Exhibit #2 shows five straight days of cross-border outflows from USTs. This is not unique to the U.S. We suspect yields are rising globally, especially in developed markets, owing to the same inflationary dynamics at work in the U.S. For as long as oil prices reflect supply concerns, we expect yields to stay well above where they were before the start of the conflict.
EXHIBIT #3: IFLOW SHOWS DETERIORATING MOOD, INFLATION HEDGING
Source: BNY Markets, iFlow
More broadly, we can trace the evolution of the market’s risk appetite through our iFlow Mood indicator. This measure, shown in Exhibit #3 in blue, compares detrended global equity flows with detrended short-duration bond flows, effectively comparing appetite for risky assets like stocks against investor appetite for safe government debt. For most of 2025 after “liberation day,” iFlow Mood remained depressed, although it did climb steadily in the second half of last year. It peaked in mid-February and dropped quickly in recent weeks, reflecting the growing risk aversion we currently observe in markets.
We also plot an inflation expectations indicator derived from our iFlow data. We look at all 24 U.S. equity industry groups and compare flows into equities that tend to perform well when inflation rises with flows into industries that tend to underperform in such environments. If investors are buying securities with a positive correlation to inflation expectations and selling those with a low correlation, we infer they are seeking inflation protection in equities.
We’re presently confronted with falling risk appetite and rising inflation expectations, driving yields higher and keeping pressure on risk assets. We expect this to continue for the duration of the conflict. The upward movement in yields will likely reverse only when crude prices fall and hostilities ease. An increase in cross-border UST outflows is a concern, especially with Treasury coupon auctions (10s and 20s) later this week.
The U.S. economy – and ultimately rates – are affected by the Middle East conflict through three channels. Higher oil prices risk inflation and have raised yields through the expectations channel, as we have noted. Financial market instability affects consumer portfolios, which through the wealth effect could depress consumer demand (as can the real income effects of higher oil prices). Asset volatility can also affect financial planning and postpone investment or hiring activities. The third channel, related to the first two, is a broad increase in economic uncertainty that depresses consumer and business behavior. The growth and inflation effects of the conflict come from the negative supply shock it creates, driving the aggregate supply curve in and to the left, raising prices and restraining output.
This sets up a dilemma for the Fed, which was already confronting sticky inflation and waning labor demand before the conflict began. Before the outbreak of hostilities, the market had discounted just over two rate cuts by the end of the year. Since then, something well short of two cuts is priced in, reflecting less dovish expectations for the central bank.
It’s true that the latest labor market data last week were quite poor, indicating something we have been watching since last summer. Outside of health care jobs, there has been close to zero net job creation in the U.S. for nearly two years. It is historically quite rare for job growth to be flat indefinitely, and such situations usually result in outright job losses. This is why we have been expecting three cuts this year from the Fed. We have been expecting materially weaker labor markets this year and may be beginning to see them if the February jobs report is indicative of subsequent trends. If the Middle East conflict eventually settles down and oil prices come back to earth, the Fed may still confront a jobs recession, even with inflation somewhat above 2%.
