Oil, Bonds, and the Fed’s Dilemma

The market is lower early Monday, with oil back up and the 20+ Year Treasury Bond Fund (TLT) hitting new multi-year lows. As I wrote Friday, that day’s bounce was defensive positioning by traders who didn’t want to be caught short if an Iran deal happened. They did not believe it would, but they hedged just in case. Over the weekend, President Trump rejected Iran’s proposal to reopen the Strait of Hormuz, so the deal did not happen, and we are giving back Friday’s gains.

Oil and Bonds Are Stuck Until Iran Moves

Without progress on Iran, it will be tough for oil or bonds to reverse, and the reason is more complicated than a single headline. The two sides are not even negotiating the same thing. Iran offered to reopen Hormuz, which is the oil issue the market cares about. Trump has shifted the focus to Iran’s nuclear program, which is what he cares about most, and Iran has given no indication it will discuss the nuclear question at all.

The headline that “talks continue this week” is misleading. They aren’t even talking about the same issue. Pressure on oil won’t ease until one side abandons its core position. There is no sign of that.

The physical oil market confirms that supply is tight regardless of deal talk. The front-month crude contract, which expires this week, trades over $107 while the more active later contract is under $100. In commodity trading, that is called backwardation, where the current price is higher than it is a few months out. That happens when supply is physically constrained today, but there is hope of some additional supply in the future. The spread does not care what anyone said over the weekend. It reflects barrels not moving through the strait, and until that changes, the front-month premium will remain.

Higher energy prices are pushing borrowing costs up worldwide, with the 10-year Treasury above 5.2% after closing last week at its highest since 2007. So the tight oil market is directly driving the bond selloff. As long as the front-month premium sits where it is, the oil-driven inflation is not fading, and the rate pressure is not easing.

The Fed’s Dilemma Is the Whole Story

This is a busy week of economic news, with PCE on Wednesday, GDP and ISM manufacturing Thursday, the jobs report Friday, and 22 Fed speaker events scattered throughout. But the Fed’s dilemma is already clear, and no single economic report will fix it.

The AI sector is hot, and it will not slow down for a few points of borrowing cost. AI is the part of the economy driving inflation higher, and it is the one part rate hikes don’t impact very much. If the Fed takes hawkish action to cool the AI-driven overheating, it does not cool AI. It hurts everything else, the parts of the economy that are already soft. Housing, small-caps, biotech, commercial real estate, the average business that lives on borrowed money.

This is the two-tiered market I’ve been writing about for months and it is a two-tiered economy underneath it. The Fed cannot narrowly target AI, so fighting the inflation AI creates means crushing the parts of the economy that are already weak.

This week’s data will either intensify that pressure or ease it slightly, but it will not change the underlying problem of a two-tiered economy. A hot PCE Wednesday makes the October hike close to certain. A soft report buys a little relief, but the structural problem remains.

Game Plan

Friday’s bounce faded as it should have, and until oil and bonds show a clear change of character, pressure on the broader market will remain a major problem.

The economic calendar is stacked with inflation data that could make the rate problem worse. So I stay patient and let it play out. My shopping list is long and getting longer, and the day it becomes actionable is the day oil finally rolls over, not the day another Iran headline crosses. There is little choice but to stay focused on the oil and bond charts and ignore the news headlines.

Position: None