There is no doubt that oil prices and bond yields have been closely connected in recent years and this correlation has worked in both directions.
One explanation is that large shifts in oil prices, caused by supply-side events in the energy markets, trigger big changes in inflation expectations that are then reflected in bond markets. On this hypothesis, rising oil prices could force the Federal Reserve to become more hawkish, threatening an unpleasant end to the economic cycle.
However, some of the links here are very dubious. It is not obvious why oil price increases should cause changes in long-term inflation expectations. The Fed and the markets normally assume that such energy shocks will have only temporary effects on the rate of change in consumer prices, provided that the credibility of the central bank’s 2 per cent inflation target remains intact. So far, that is not in any danger.
A different explanation for the recent link between bond yields and oil prices is that both of these variables have been driven by a third factor, such as demand shocks in the US or global economy. An upward demand shock is likely both to raise oil prices and to increase bond yields simultaneously. But that explanation would have less pessimistic implications for equities, because the benefits to profits from higher demand would offset the damage done to valuations from higher bond yields.
It is not completely clear which of these explanations is the more compelling at present.
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