The U.S. Treasury Department in Washington. Bonds have endured a rough few weeks since the U.S. and Israel attacked Iran.ALASTAIR PIKE/AFP/Getty Images
Soaring energy prices and rising bond yields have put inflation back into the conversation as war rages in the Middle East. Is there a play on peace here?
Bonds have endured a rough few weeks since the United States and Israel attacked Iran at the end of February.
The war has driven up the price of crude oil – which has been flirting with levels close to US$100 a barrel this week – by about 70 per cent since the start of the year as exports through the Strait of Hormuz slow to a trickle.
The cost of filling up our cars and flying to sunny destinations overseas is rising. And that is giving central bankers plenty to think about as they weigh uneven economic activity and a vulnerable job market against the threat of rising inflation.
The Federal Reserve and the Bank of Canada held their respective interest rates unchanged this week, as expected. But their assurances did nothing to calm financial markets that are growing wary of another round of inflation.
The bond market can sniff trouble, as yields rise and prices fall.
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The yield on the 10-year U.S. Treasury bond rose to 4.39 per cent early Friday, marking its highest level of the year. Before the war began, the yield was below 4 per cent.
The yield on the more rate-sensitive two-year note is at its highest level since July.
And here at home, the yield on the Government of Canada five-year bond rose above 3.2 per cent early Friday, from below 2.7 per cent before the war began.
These aren’t huge moves. Recall that the U.S. Treasury bond peaked at about 5 per cent in 2023, when the Fed raised rates aggressively in its battle against the worst bout of inflation in decades.
But the direction is troubling. Rising yields interrupt what had been a pleasant, if slow, recovery in the bond market over the past couple of years.
The BMO Aggregate Bond Index ETF – a $12.2-billion fund that provides easy access to Canadian investment-grade federal, provincial and corporate bonds and serves as a useful proxy for fixed income – has fallen 2.6 per cent since the war began (not including distributions).
If concerns about inflation grow worse – say, through an escalating Middle East conflict with uncertain goals and sustained higher oil prices that filter through the rest of the economy – the bond market could be a downer this year.
But here’s a thought: In a difficult environment for investors, marked by high stock valuations, an energy rally that may be growing old and a precious metals market that may be faltering, bonds appear to offer an attractive alternative.
Okay, cue 2021, when central bankers argued that rising inflation then was a product of pandemic-era supply chain bottlenecks that would prove transitory, or brief.
Inflation proved far stickier than expected, forcing central banks to raise their key interest rates aggressively into 2023 – walloping bonds in the process.
The BMO Aggregate Bond Index ETF slumped more than 18 per cent over this rate-hiking period, as bond yields surged (again, not including distributions and using the fund merely as a proxy for fixed income).
Nearly three years later, bonds still haven’t recovered: Prices are low, yields are relatively high. Today’s rising inflation expectations aren’t helping matters.
Nonetheless, the case for bonds is compelling.
Though central banks are wary of another bout of inflation, they are also weighing a batch of recent disappointing economic data.
U.S. economic growth slowed to just 0.7 per cent in the fourth quarter of 2025, at an annualized pace, according to the Commerce Department. Just as troubling, the economy shed 92,000 jobs in February.
Some observers expect that these weak readings will keep the central bank on track for cutting rates, which could help the bond market.
“We continue to expect two rate cuts from the Federal Reserve during the second half of the year, which will bring rates down close to a neutral level,” Andrew Grantham, an economist at CIBC Capital Markets, said in a note.
Mr. Grantham cautioned that this forecast rests on the assumption that the conflict in the Middle East ends soon, gasoline prices decline and inflationary pressures subside.
Those seem to be reasonable expectations.
The S&P/TSX Energy Index has rallied about 80 per cent over the past year, but most of that gain occurred before the conflict began. The index is up just 15 per cent since the attacks on Iran, which is hardly a vote of confidence in a lingering conflict.
If peace prevails, bonds looks like a good bet.