International crude oil futures settlement prices have broken through the $90 mark, reaching their highest level since October 2023. Both WTI and Brent crude recorded their largest weekly gains since records began in 1983 and 1991, respectively. The April WTI crude contract settled up 12.21% at $90.9 per barrel, accumulating a 35.6% gain for the week. The May Brent crude contract rose 8.52% to $92.69 per barrel, finishing the week 27.88% higher.

The spike in energy prices, driven by conflict in the Middle East, has prompted investors to rush into the US bond market to purchase products that offer protection against inflation, pushing valuations for some bonds to their highest levels in nearly a year. In the US Treasury and inflation swap markets, investors can secure payments linked to the US Consumer Price Index (CPI). However, the cost of these payments has surged alongside oil prices following attacks by the US and Israel on Iran over the weekend and subsequent retaliation by Iran.

Pressure to hedge against rising prices has bolstered demand for short-term Treasury Inflation-Protected Securities (TIPS), whose yields have risen less than those of traditional bonds. Consequently, the current yield on a standard 5-year US Treasury note is approximately 3.7%, which, relative to the 5-year TIPS yield of about 1.05%, represents the highest level since April. This yield differential serves as a gauge for the market's average expected inflation rate over the next five years.

"The current environment makes TIPS very attractive because their cash flows increase with rises in the CPI," said Jon Hill, head of US inflation strategy at Barclays Capital. "And we know that rising energy prices ultimately push up gasoline prices, which then feed into the CPI."

Investors faced a more complex economic picture on Friday. Surprisingly weak US non-farm payroll data for February caused Treasury yields to fall for the first time this week. Simultaneously, the price of the US benchmark crude futures contract climbed to its highest level this year. The demand for protection is also evident in inflation swaps, where the cost of hedging against inflation has jumped sharply. The implied rate for a one-year CPI swap is near 2.9%, compared to about 2.5% just a week ago.

According to Gang Hu, Managing Partner at Winshore Capital Partners, short-term TIPS offer the dual appeal of higher inflation-adjusted interest payments and the near-certainty that the Federal Reserve will not raise interest rates in response to a transient inflationary shock caused by oil prices. "Short-term inflationary pressures will be very high. At the same time, short-term real rates should decline because the Fed is unlikely to hike rates due to an inflation shock," Hu stated.

Although expectations for Fed monetary policy easing this year have diminished with the rise in oil prices, traders still anticipate at least one interest rate cut. The rising oil prices have pushed up the US national average retail price for gasoline, which increased by approximately 3.32% on March 5th from a price slightly below $3 on March 1st. In January, gasoline costs accounted for 2.9% of the US CPI.

For consumers, short-term inflation expectations are "largely driven by gasoline prices because they are so visible and most people see them change regularly every week," said Omair Sharif, President of Inflation Insights LLC. Sharif added that rapid price swings, similar to those seen during the 2022 Russia-Ukraine war, can also influence longer-term inflation expectations.

The US government is scheduled to release the February CPI report next week, which is expected to show a year-on-year increase of 2.4%, unchanged from January. Since mid-2023, the overall inflation rate has generally stayed below 4%, after peaking at 9.1% in 2022.

"Based on the latest move in oil prices, the distribution of risks for oil price movements has likely shifted significantly higher today, which would provide more support for TIPS," said Phoebe White, head of US inflation strategy at JPMorgan Chase & Co. She noted that investor positioning is also a factor, as market inflation expectations had declined in February due to concerns about disruptive risks from artificial intelligence and worries about private credit.

The strength in TIPS this week has been concentrated primarily in short-term bonds. The 30-year US TIPS breakeven inflation rate sits around 2.22%, near the lower end of its range over the past year. Hu pointed out that one reason for this is that, over the long term, rising oil prices can be deflationary because increased spending on gasoline curtails consumption of all other goods. Furthermore, slowing US economic growth leading to reduced tax revenues, combined with increased military spending, could widen the US budget deficit, necessitating more borrowing and thereby putting pressure on bond prices. "Long-term fiscal conditions are always worse during wartime. This will push up long-term rates—both nominal and real," Hu said.