U.S. Treasury bond prices rebound as market trading logic quietly shifts

Source: Shanghai Securities Journal · China Securities Journal

Shanghai Securities Journal China Securities Journal News (Reporter Huang Bingyu): In the past two trading days, the U.S. bond market has rebounded from a sell-off, showing signs of “decoupling” from oil. Previously, during the past few weeks, concerns about inflation triggered by soaring oil prices led the market to expect the Federal Reserve to raise interest rates, causing U.S. bond yields to rise sharply and prices to continue falling.

Analysts generally believe that this change marks an initial shift in market focus—investors are beginning to worry that the long-term impact of geopolitical conflicts on economic growth will surpass inflation itself, with trading logic showing signs of switching to stagflation and recession scenarios. Additionally, concerns about the sustainability of U.S. fiscal policy are deepening, with expectations that the U.S. government may expand fiscal spending to cope with economic pressures, further increasing debt burdens and term premiums.

U.S. bond yields sharply retreat

Since the outbreak of the Middle East geopolitical conflict, rising oil prices have increased inflation expectations, and global bond markets have been pricing in “inflation trades,” with U.S. bond yields and energy prices moving in tandem.

However, at the end of March, the U.S. bond market showed signs of “decoupling”—crude oil remained high, but bond prices began to rebound, and yields turned lower. During the trading session on April 1, U.S. bond yields continued to decline, and by midday on April 2, as of 11 a.m., the 10-year U.S. Treasury yield had fallen from a recent high of 4.48% at the end of March to around 4.35%; the 2-year yield also retreated to about 3.8%.

The latest dovish stance from Federal Reserve Chair Jerome Powell was a key catalyst for this shift. On March 30, Powell stated that amid the energy shocks caused by geopolitical conflicts, the Fed tends to keep interest rates unchanged and “ignore” the impact of these shocks for now. This rhetoric further boosted bond markets.

Bai Xue, Senior Deputy Director of Research and Development at Orient Securities, told the Shanghai Securities Journal that in the past month, inflation trades dominated the market, with Middle East conflicts pushing oil prices higher and hawkish signals from the Fed, which cooled expectations of rate cuts and even began pricing in rate hikes within the year, pushing U.S. bond yields higher. However, after the conflict persisted for a month, investors started to worry that the long-term impact on economic growth would far exceed inflation, evidenced by the weakening response of U.S. bond yields to rising oil prices, even turning downward. Additionally, the U.S. bond market had previously been overly bearish, creating valuation repair needs, and institutions began to buy on dips, which also contributed to the downward pressure on yields.

Trading logic begins to shift

The significant decline in U.S. bond yields over the past two days also indicates a rapid change in market focus—from “inflation risk” gradually shifting to “growth stagnation.”

Regarding the Middle East conflict, the evolution of market allocation logic follows certain patterns. Cheng Zeyu, Senior Analyst at China United Assets Securities’ Sovereign Department, told the Shanghai Securities Journal that initially, the market adopted a “cash is king” defensive stance. As recession signals confirmed, the trading logic would shift from “anti-inflation” to “defense against recession.”

Bai Xue believes that the current market pricing is in a transitional period from “inflation shocks” to “growth shocks,” which is well reflected in the abnormal correlation of asset prices over the past two days.

Although inflation concerns remain, as expectations for prolonged and persistent Middle East conflicts deepen, the market is beginning to worry that the dual pressures of soaring energy prices and high interest rates could drag down economic growth.

As for when the “recession trade” will arrive, Bai Xue suggests paying attention to key signals: first, a sharp rise in oil prices alongside a significant decline in medium- and long-term inflation expectations, which is an important indicator of recession risk; second, a continued decoupling of oil prices from U.S. bond yields, indicating that recession fears have overtaken inflation panic; third, persistent deterioration in economic or employment data in major economies; fourth, a policy shift by the Fed, such as signaling rate cuts or explicitly prioritizing economic growth amid inflation not yet reaching target levels and increasing downward pressure on the economy.

“Going forward, attention should be paid to the duration and scope of the Middle East conflict, oil price trends, inflation readings in major economies, employment market trends, and economic activity indicators to assess inflation and growth risks,” said Ming Ming, Chief Economist at CITIC Securities.

Concerns over fiscal sustainability limit the space for rates to fall

The “decoupling” also reflects market expectations of U.S. fiscal stimulus. Bai Xue explained that the logic behind this is that rising oil prices exacerbate inflationary pressures and erode consumer purchasing power, leading markets to expect the U.S. government to expand fiscal spending to counteract economic pressures from rising prices. This fiscal stimulus expectation increases bond supply expectations, preventing yields from rising in tandem with oil prices, thus creating a “decoupling.”

Currently, the U.S. federal debt has surpassed $39 trillion, hitting a record high. Bai Xue noted that on one hand, the expanding debt and increasing fiscal deficits could shake investor confidence in U.S. bonds, reducing demand from international buyers. On the other hand, concerns that fiscal stimulus will further boost inflation could force the Fed to keep interest rates high, increasing the interest burden on bonds and creating a “debt-interest rate” vicious cycle.

Looking ahead, Bai Xue believes that in the short term, if debt issues trigger fears of economic slowdown, safe-haven funds may flow into U.S. bonds, putting downward pressure on yields. However, in the medium to long term, Ming Ming states that the Fed’s pace of rate cuts has further slowed, and with inflation risks, the room for rate cuts is limited. This increases the pressure of U.S. fiscal spending, especially interest payments. Market concerns about U.S. fiscal sustainability and inflation outlook are expected to support long-term bond yields, making further declines in long-term yields relatively limited.

“Concerns over U.S. bond fiscal sustainability will push up the term premium, and combined with high interest expenses, will form a negative feedback loop of ‘rising rates—heavier interest burdens—larger deficits—increased supply,’ putting systemic upward pressure on U.S. bond yields,” Bai Xue said.