If the US economy can easily digest high interest rates, why wouldn’t it handle expensive oil as well? The correlation between Treasury yields and “black gold” is currently breaking all records, forcing investors to closely monitor commodity markets. The logic is simple: the higher Brent climbs, the greater the risks of accelerating inflation and, consequently, more aggressive Fed tightening. This pushes debt market rates up and strengthens the dollar. But have Treasuries gotten too far ahead of themselves?
From the standpoint of classical theory, an oil rally should primarily drive up the yields of short-term bonds, as they are the most sensitive to the Federal Reserve’s monetary policy. Long-term Treasury yields, conversely, would typically rise amid an unchecked surge in Brent. However, if North Sea oil simply anchors around the $100 per barrel mark and stays there, it is unlikely to trigger a long-term inflationary spike. Rather, such a price shock would hit economic activity, which could eventually cool down prices.
Is the US government bond market making a colossal mistake by reacting so nervously to Brent quotes? Not necessarily. First, expensive energy resources could force the government to introduce subsidies and protective measures, which would bloat the budget deficit and national debt, automatically pushing Treasury yields higher. Second, the US economy, fueled by the artificial intelligence boom, might prove to be so robust that it can comfortably foot any oil bill. In that scenario, current debt market rates are entirely justified. As is the 50% probability priced in by futures that the Fed will raise rates by another 100 basis points over the next year.
Interestingly, the Eurozone economy is also demonstrating enviable resilience. Business activity in the region has reached a three-year peak, and Germany’s Ifo business climate index has been rising for the fifth consecutive month. Furthermore, the European Commission has officially stated there is no shortage of diesel fuel in the region, which seemingly defuses the threat of a new energy crisis. The price gap for oil products between Europe and the US is also significantly narrower than it was during the shock of 2022.
But the devil is in the details—or more precisely, in the structural differences between the economies. The US is a net exporter of energy resources, meaning high oil prices work to its economic advantage, generating additional revenue. The Eurozone, on the other hand, has to pay for this oil, and at inflated prices. For the Old World, the “oil – inflation – monetary policy” nexus is far more vulnerable and dangerous. There is also a higher risk that the ECB, in its attempt to combat inflation, might overdo the tightening and push the region into a recession.
This is precisely why the probability of the Fed continuing its tightening cycle in October (estimated by the market at 70%) significantly outweighs the ECB’s chances. Given these macroeconomic realities, it is hardly surprising that the euro is steadily losing its footing.
