Oil and Treasury yields haven’t moved this closely in seven years. That’s bad news for markets

Oil prices and Treasury yields are moving in lockstep, compounding the pressure on markets as investors grapple with another inflation shock.

The one-month rolling correlation between front-month West Texas Intermediate crude and the 10-year Treasury yield has climbed to 0.96, according to BMO Capital Markets. That's the strongest positive relationship since June 2019, and before that October 2014.

The synchronized moves come as oil prices have surged due to the conflict in the Middle East, while the benchmark 10-year Treasury yield briefly topped 5% Monday for the first time since October 2023.

The exceedingly tight relationship means another leg higher in oil could increasingly reverberate across financial markets through higher inflation expectations, elevated Treasury yields and steep borrowing costs, while potentially keeping the Federal Reserve monetary policy tighter for longer, said industry veterans.

Treasury yields stay elevated

"The main impact is that an oil shock now transmits more directly into financial conditions," said Billy Leung, investment strategist at Global X ETFs. "Higher crude can lift inflation expectations, delay Fed easing and raise the discount rate applied across equities and credit at the same time." 

"That makes energy headlines more consequential for broader markets and reduces some of the diversification investors would normally expect between commodities and government bonds," he added. 

The implications stretch across asset classes.

Higher Treasury yields reduce the relative appeal of equities as they raise financing costs for businesses, while expensive oil squeezes margins for companies dependent on energy and transportation.

Growth and technology stocks can be particularly exposed because their valuations depend heavily on earnings expected far into the future.

Ed Yardeni, president of Yardeni Research, said the chain increasingly runs from energy through inflation and bonds into monetary policy and equities.

"It's certainly bad news that if oil prices continue to move higher, that would indicate that bond yields are moving higher, and then higher inflationary expectations raise the odds that we'll be in a tightening cycle when it comes to the Fed funds rate," Yardeni said.

"Not one and done, but there there could be two or three rate hikes up ahead here, and that in turn can certainly be unsettling for the stock market." 

Komal Sri-Kumar, president of Sri-Kumar Global Strategies, is already steering investors away from assets most vulnerable to higher rates. He favors short-duration fixed income and defensive equities, while recommending physical assets including real estate, copper and gold as hedges. He said technology growth stocks are more vulnerable as interest rates remain elevated.

"You're going to have a bond bear market, the yields headed up, and I don't see anything that stops the upward march of oil and natural gas prices either," said Sri-Kumar.

Consumers face a similar double hit.

Higher energy prices feed directly into gasoline costs and indirectly into goods and services transported by truck and rail, while rising Treasury yields filter into mortgages, auto loans and other borrowing costs, said Andy Lipow, president of Lipow Oil Associates.

"Both increase in the WTI crude price, along with the increase in the treasury yield, are bad news for the consumer," Lipow said.

For businesses, higher yields also raise the cost of financing inventories and investment, potentially weighing on capital-intensive projects such as the buildout of artificial intelligence and the energy infrastructure needed to support it, Lipow said.

While oil and Treasurys have entered a tighter relationship, it may not be so if global tensions recede.

Leung said the 0.96 correlation is unusually high but could unwind rapidly if geopolitical tensions ease or growth fears begin to dominate. Lipow similarly said the magnitude partly reflects the relatively short period since the U.S.-Iran conflict began.