Why Aren't Surging Oil Prices Pushing Up Interest Rates? What Is the Market Afraid Of?

Since the closure of the Strait of Hormuz on March 2, approximately 17.8 million barrels per day of global oil flow have been cut off. In March alone, Brent crude surged nearly 60%, and WTI rose about 53%. This marks the steepest monthly gain for the Brent contract since its inception in 1988, surpassing the 46% record set during the 1990 Gulf War.

Conventionally, soaring oil prices drive up inflation expectations, and bond yields should follow suit. For most of the past two decades, oil prices and the 10-year U.S. Treasury yield have indeed been positively correlated. But this time, they diverged.

In the first three weeks of March, they were still moving upward in sync. WTI rose from $67 to $100, and the 10-year yield climbed from 4.15% to 4.44%. The turning point occurred between March 27 and 30: while oil prices continued to surge, the yield plummeted from 4.44% to 3.92%, a drop of 52 basis points over three trading sessions, breaking below the psychologically significant 4% level.

This is a classic "flight to safety" into bonds, with the bond market making a judgment: growth risks have now outweighed inflation risks. As the economic research firm Oxford Economics put it, "risks to growth have begun to outweigh inflation risks." In other words, the market hasn't stopped fearing inflation; it's now more afraid of a recession.

This decoupling is uncommon, but each time it has occurred, the subsequent story hasn't been positive.

Over the past half-century, there have been five instances where oil prices surged more than 35% in a short period. Following the 1973 oil embargo, U.S. GDP subsequently fell by 4.7%. After the 1979 Iranian Revolution, global GDP deviated from its trend growth rate by 3 percentage points. The 1990 Gulf War led to a brief U.S. recession. When oil prices peaked at $147 in 2008, although the financial crisis was the primary cause of the recession, the oil price shock accelerated the economic downturn. The only exception was the oil price spike driven by the 2022 Russia-Ukraine war, which did not trigger a recession, but the cost was the most severe inflation in 40 years.

The surge in March 2026 exceeded all the above cases. According to research by Federal Reserve economist James Hamilton, there is no mechanical link between oil price shocks and recessions, but "the larger the net oil price increase, the more significant the dampening effect on consumption and investment." Goldman Sachs has raised its U.S. recession probability to 30%, while consulting firm EY-Parthenon puts the figure at 40%.

The market's reaction speed has also been unusually fast.

In early March, the CME FedWatch tool showed the market expected three rate cuts for the year, with a 70% probability of a cut in June. Then, as oil prices continued to climb, the U.S. import price index jumped 1.3% on March 26, and incoming Fed Chair Kevin Warsh hinted that the neutral rate might be higher. That day, the probability of a rate hike within the year soared to 52%, and the 10-year yield touched 4.35%. FinancialContent dubbed this day "The Great Hawkish Pivot."

Four days later, the narrative completely flipped. On March 30, consumer confidence data plunged significantly, manufacturing unexpectedly contracted, and the 10-year yield crashed to 3.92%. According to FinancialContent, market bets on a dovish Fed pivot in May rose to a 65% probability. Goldman Sachs stated the market had bet the wrong way on the direction of rate hikes. That same day, Powell told undergraduates at Harvard University that the Fed "has not yet reached the moment where it must decide whether to look through the war shock," but emphasized that "the anchoring of inflation expectations is key."

According to Axios, Powell's remarks were interpreted by the market as: the Fed neither wants to raise rates to fight inflation nor is it in a hurry to cut rates to rescue the economy. Instead, it is waiting to see whether this supply shock is temporary or persistent. But the bond market can't wait any longer.

If history is any guide, Citi strategist McCormick put it most bluntly: what lies ahead is stagflation, which is bad for bonds and bad for stocks.

The Great Stagflation from 1973 to 1982 provides a report card on asset returns. Gold delivered a real annualized return of +9.2%, the commodity index (S&P GSCI) gained 586% cumulatively over the decade, and real estate returned +4.5%. In contrast, the S&P 500's real annualized return was -2%, and long-term Treasuries returned -3%. According to NYU Stern historical data, long-term Treasuries suffered a -8.6% loss in 1979 alone.

The traditional 60/40 portfolio (60% stocks + 40% bonds) gets crushed in stagflation. Only real assets can outpace inflation. Societe Generale forecasts a Brent average of $125 in April, with a "credible peak" reaching $150. Goldman Sachs is slightly more moderate, expecting an April average of $115, but assuming the Strait of Hormuz reopens within six weeks, with prices falling back to $80 by year-end.

The bond market has already made a choice for everyone. Between inflation and recession, it's betting on recession.