The Iran war drives up oil prices, but the market "ignores inflation"? Analysts warn: TIPS liquidity premium masks real risks

After the outbreak of the Iran war, energy prices surged significantly, but the market's pricing reaction to inflation has been surprisingly calm. Bloomberg macro strategist Simon White warns that this calm is not only an illusion; the risks hidden behind it are more severe than the surface data suggests.

The moderate rise in inflation breakeven rates is being masked by changes in the liquidity premium of the TIPS market. White's analysis shows that after excluding the disturbances of the liquidity premium, the market's actual implied inflation expectations have hardly increased; some indicators even declined after the outbreak of the war.

This means that the market is replaying the judgment of "inflation is only temporary" that followed the COVID-19 pandemic and the Russia-Ukraine conflict, a judgment that has previously been proven wrong.

At the same time, the rapid adjustment of interest rate expectations, the pressure on term premiums, and the policy signals released by the potential new Federal Reserve chair all constitute a set of internally contradictory market logic.

White warns that once the credibility of policy is damaged, both nominal yields and term premiums may be forced to reprice, and the impact will far exceed the current market's expectations.

Limited Rise in Breakeven Rates, "Temporary Theory" Returns

Since the outbreak of the Iran war, the rise in U.S. inflation breakeven rates has been far lower than in historically comparable events. The 2 to 5-year breakeven rates have risen by about 20 to 35 basis points, while the 10-year breakeven rate has increased by less than 10 basis points.

In contrast, after the Russia-Ukraine conflict in 2022, the 10-year breakeven rate once soared nearly 100 basis points. Although the spot inflation level was higher at that time, the degree of the market's response this time is still significantly lower than historical references.

White points out that the market's "muscle memory" is at play—after enduring the tests of the pandemic and the Russia-Ukraine conflict, the core belief that "inflation is only a temporary phenomenon" remains deeply entrenched, and investors generally expect that the impact of this energy price shock on CPI will be short-lived.

Liquidity Premium Dilutes Inflation Signals, Real Expectations May Be Lower

However, breakeven rates themselves are not an accurate tool for measuring inflation expectations. White explains that breakeven rates are essentially equal to inflation expectations minus the TIPS liquidity premium. When the liquidity premium decreases, even if inflation expectations remain unchanged, breakeven rates will rise accordingly, leading to misleading signals.

Crude oil prices have historically been one of the most recognized real-time inflation indicators in the market. When oil price shocks occur, investor demand for TIPS often rises rapidly, lowering the liquidity premium, which is the main pricing driver in the TIPS market during the initial phase of an oil price shock.

White uses the historical series of the 5-year TIPS liquidity premium calculated by the Federal Reserve based on the DKW model and conducts a regression analysis with oil prices. The results show that since the outbreak of the war, this liquidity premium has decreased by about 20 basis points—roughly equivalent to the rise in the 5-year breakeven rate.

In other words, the rise in breakeven rates has largely, if not entirely, been offset by the decline in the liquidity premium, and the market's implied underlying inflation expectations may have hardly moved, or even net declined Through another estimation method—observing the spread between inflation swap rates and breakeven rates (swaps do not occupy balance sheets, and the liquidity premium is smaller)—similar conclusions are drawn: significant oil price surges have historically been accompanied by a decline in TIPS liquidity premiums, and this time is no exception.

Contradiction in Real Yield Upward Logic, Term Premium Under Pressure with Hidden Risks

Why are real yields still rising? White believes that this is mainly due to the market's elevated expectations for higher policy rates, rather than an improvement in expectations for real economic growth—the latter should be under pressure due to the oil price shock.

Another contradiction worth noting is that the upward space for term premiums has been significantly compressed. In the composition of nominal yields, the contribution of term premiums is relatively limited, which itself may be a dangerous complacency.

White points out that term premiums can be further broken down into three parts: inflation expectations, inflation term premiums, and real term premiums.

If long-term inflation expectations do not see substantial upward adjustments, inflation term premiums will also struggle to obtain adequate risk compensation—while inflation itself has "heteroscedasticity," meaning that as inflation levels rise, its volatility will also increase, and the market seems to be underpricing this.

Conflicting Policy Signals, Yield Curve Faces Revaluation Risks

At the policy level, the current pricing logic in the market also has inherent tensions. White notes that the market is eagerly raising interest rate expectations.

However, at the same time, Kevin Warsh, a popular nominee for the Federal Reserve Chair, is not seen as a strong hawkish figure, while President Trump continues to pressure the current Federal Reserve Chair to cut rates immediately. These two signals are contradictory and difficult to coexist.

White warns that if the market's confidence in the credibility of policy wavers, the chain reaction will exceed the expectations of rate cuts themselves; inflation expectations and term premiums will be forced to adjust upwards simultaneously, and nominal yields may even rise overall, rather than decline.

At that time, the yield curve may steepen—similar to the market trends during the first oil crisis of OPEC after the "Day of Atonement War" in 1973, when the Federal Reserve, under Arthur Burns, who had close ties to the White House, paid a heavy price due to the loss of policy credibility.

"Inflation will eventually make its voice heard in some way," White writes, "just don't think that the long-end breakeven rates are the right place to listen to it."