Falling oil no longer signals lower yields, BofA says

Investing.com -- Bank of America said U.S. front-end real yields are likely to remain elevated even as oil prices have retreated, arguing markets are increasingly pricing a tougher Federal Reserve response to persistent inflation rather than simply tracking moves in crude prices.

The bank said resilient economic data and renewed upside risks to oil support maintaining bearish positions on short-dated Treasury rates and inflation-linked trades.

The view marks a departure from the close relationship seen earlier this year, when two-year Treasury yields largely moved in tandem with oil prices. Since crude peaked, however, front-end yields have remained elevated as investors reassess the Fed's reaction function and price in a more aggressive stance against inflation, the bank said.

The outlook suggests investors should focus less on falling energy prices and more on the Fed's determination to restore inflation to its 2% target. Higher real yields tighten financial conditions and typically weigh on interest rate-sensitive assets, while also supporting the U.S. dollar and short-term Treasury yields.

Bank of America said part of the recent rise in real yields reflects technical factors, including strong carry in Treasury Inflation-Protected Securities (TIPS), but argued markets still have room to price a more hawkish Fed response to upside inflation risks. It reiterated its recommendation to remain short two-year U.S. rates while favoring forward real-yield curve flatteners because of attractive carry and roll dynamics.

The bank also said current market pricing implies an unusual steepening of forward real-rate curves even as inflation curves are expected to flatten, a scenario it considers unlikely. Instead, it expects resilient U.S. growth and renewed upside risks to oil prices to keep front-end real yields elevated, reinforcing its preference for two-year rate shorts, one-year/two-year inflation swap flatteners and forward real-yield flatteners.

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