Bond storm of 2026 may be passing, but Fed gusts linger: Mike Dolan
By Mike Dolan
LONDON, Nov 11 (Reuters) - The great sovereign bond storm of 2026 may be clearing, as an apparent truce in the US-Iran war offers investors their first glimpse of calm after months of oil-fueled turmoil.
Oil defined the year in bonds. Washington's shifting tone toward the Iran conflict since last week's midterm elections may be the biggest catalyst going forward.
US President Donald Trump has repeatedly indicated this week that the war is "effectively over," and his administration seems keen to take voters' message square on the chin.
The war was hugely unpopular mainly because it raised US crude and fuel costs, which seeped into broader inflation and, eventually, Federal Reserve interest-rate rises since September.
The combination of fuel-stoked inflation and higher borrowing costs has proven politically toxic before, most recently during the 2024 White House race that Trump capitalized on.
But if this war is indeed effectively over and oil-price risk premia seep away, can bond investors view the eight-month conflict as a bad dream and snap up the multi-decade-high yields on offer?
That question is now central to myriad year-ahead strategies.
Surprise attacks by the US and Israel on Iran in February sent oil prices soaring by halting the flow of a fifth of the world's crude supplies through the Persian Gulf.
Brent crude futures rocketed more than 70% to a four-year high of $120 per barrel in April, before falling below $90 this week.
That, however, is still almost 30% higher than in February.
A deal to keep the Strait of Hormuz open could quickly erase the remaining war premium, but strained refining capacity means it may take even longer for fuel prices to fall.
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Average US regular gasoline pump prices slipped on Tuesday below $4 per gallon for the first time since July, according to AAA, but they remain some 35% above pre-war levels.
Data on Tuesday also showed that inflation remains high and is running at almost twice the Fed's target.
Treasury markets have tracked oil closely all year, and yields are well off their multi-decade peaks of just over a month ago.
Like still-elevated energy costs, two-year Treasury yields remain a whopping 150 basis points above their pre-war level. At around 5%, 10-year yields are about 100 bps higher than in February.
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Will energy and debt costs now simply deflate if the war winds down? The Fed was expected to cut rates when the war broke out, and some might hope it turns the clock back too.
Not so fast.
TWICE THE DOSE
Before Tuesday's worryingly hot consumer price report for October, Fed Governor Christopher Waller threw a curveball by suggesting the central bank may need to get even tougher.
Waller said that a core consumer price rise of 0.3% for October would prompt him to consider a half-point hike at the Fed's December 8-9 meeting, twice the size of the usual Fed increment. That was the reading later in the day, prompting Fed futures to price in an outside chance that next month's hike could exceed 25 bps.
Waller argues that officials misjudged policy's effect on the economy: it is not nearly restrictive enough to return inflation to target, particularly with the labor market tightening again.
At annual headline inflation rates almost twice the central bank's target, real Fed policy rates are still close to zero even though unemployment is only 4.1%, the economy is likely growing at more than 3%, and financial conditions are still historically loose.
"Inflation looks like it's starting to go away from our target, not closer," Waller said. "Then you have to be more aggressive (with) your monetary policy."
Dallas Fed President Lorie Logan chimed in later, saying policy was still about 50 bps below the modestly restrictive level required. She said it was possible to "move more rapidly" this winter to get there.
The rhetoric may reflect last month's pre-election pause, but an oil-price swoon would not much alter their destination.
Both officials acknowledged the post-election retreat in energy prices but insisted energy was not the only thing driving inflation. Waller also stressed that damaged refining capacity could delay any further drop in crude prices from reaching retail and business fuel costs.
Steeper rate rises over the next two months could cool the economy faster and clear the air for bonds next year.
SUSTAINING THE DEBT
The bond market has other issues to contend with beyond oil prices.
Ballooning annual budget deficits and rising debt piles are raising questions about debt sustainability and lifting related risk premia, with little political appetite to address them.
What's more, the economic heat of the AI investment boom has stoked inflation and unleashed a borrowing spree by so-called "hyperscalers," a bond binge that puts them in competition with governments for savings seeking top-rated debt.
The political quake at the US midterms may also slow the data-center buildout — and with it the spending, borrowing and GDP boost behind it.
Describing post-election questions around the AI buildout as creating "two-sided uncertainty," BlackRock strategists this week offered one reason for turning more positive on Treasuries last month.
"A material slowdown in 2027, though far from certain, could have significant adverse market consequences," they said. "But it could also ease competition for capital and lower bond yields, while its economic fallout could temper policy initiatives."
Despite inflation and Fed headwinds, long-dated government debt could improve on several fronts next year.
Morgan Stanley's annual debt sustainability analysis last week noted that despite this year's anxiety over sovereign bonds, the burst of nominal growth from AI spending and higher inflation actually improved short-term sustainability-model readings for many economies.
However, higher servicing costs associated with higher bond yields kick in with a lag as debt is refinanced, and budget consolidation is still sorely needed in many countries, the report added.
Getting yields down will be critical to keeping the bond-market coast clear, returning the focus to oil and central banks. Yet this year's sense of jeopardy in bonds may finally be ebbing.
(The opinions expressed here are those of Mike Dolan, a columnist for Reuters.)
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