Iran war pushes 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, but the market's inflation pricing response was surprisingly calm. Bloomberg macro strategist Simon White warns that this calmness is not only an illusion, but the risks hidden behind it are more severe than what surface data suggests.

The moderate upward movement in breakeven inflation rates is being masked by changes in the liquidity premium of the TIPS market. White's analysis shows that after eliminating the disturbances of the liquidity premium, the actual implied inflation expectations in the market have barely risen at all, and some metrics have even declined after the outbreak of the war.

This means the market is replaying the post-pandemic and Russia-Ukraine war judgment that "inflation is only temporary," a judgment that has previously been proven wrong.

Meanwhile, the rapid upward adjustment in interest rate expectations, the squeezed term premium, and the policy signals released by the potential incoming Federal Reserve Chair together form a set of internally contradictory market logic.

White points out that if policy credibility is damaged, nominal yields and term premiums may be forced to reprice, and the impact would far exceed current market predictions.

Limited rise in breakeven rates, "temporary inflation" narrative returns

Since the outbreak of the Iran war, the rise in U.S. breakeven inflation rates has been far below comparable historical events. The 2-to-5-year breakeven rates rose about 20 to 35 basis points, while the 10-year breakeven rate’s increase was less than 10 basis points.

By contrast, after the 2022 Russia-Ukraine conflict, the 10-year breakeven rate soared nearly 100 basis points. Although the spot inflation level was higher at that time, this round’s market response remains notably milder than historical precedents.

White points out that the market’s “muscle memory” is at work—having been tested by the pandemic and Russia-Ukraine conflict, the core belief that “inflation is only a temporary phenomenon” remains deeply rooted, and investors generally expect the current energy price shock’s impact on CPI will be brief.

Liquidity premium dilutes inflation signal; actual expectations may be even lower

However, breakeven inflation rates themselves are not precise tools for measuring inflation expectations. White explains that the breakeven rate essentially equals inflation expectation minus TIPS liquidity premium. When liquidity premium falls, even if inflation expectations remain unchanged, breakeven rates rise accordingly, producing misleading signals.

Crude oil prices have always been one of the most recognized real-time inflation indicators by the market. During oil price shocks, investor demand for TIPS rises rapidly, suppressing liquidity premium—this is the main pricing driver for TIPS in the early stages of oil price shocks.

White uses the Federal Reserve’s DKW-model-based historical series for the 5-year TIPS liquidity premium, regressing it against oil prices. The results show that since the outbreak of the war, this liquidity premium has declined by about 20 basis points—almost identical to the increase of the 5-year breakeven rate.

In other words, the rise in breakeven rates has been largely, or even entirely, offset by the fall in the liquidity premium; the market’s implied fundamental inflation expectations have in fact barely moved, and may have even decreased.

Using another estimation method—observing the spread between inflation swap rates and breakeven rates (swaps do not occupy balance sheet and have lower liquidity premium)—produces similar results: every time oil prices have surged sharply, TIPS liquidity premium has fallen, and this time is no exception.

Logic of real yields’ rise is contradictory; squeezed term premium poses latent risks

Why are real yields still rising? White believes this mainly stems from the market raising expectations for higher policy rates, not from improved real economic growth expectations—the latter should be under pressure in an oil price shock.

Another contradiction worth noting is that the upward room for term premium is clearly compressed. Within nominal yields, the contribution of term premium is relatively limited, and this could itself be a dangerous complacency.

White notes that term premium can be further broken down into inflation expectation, inflation term premium, and real term premium.

If long-term inflation expectations do not rise substantially, then inflation term premium likewise struggles to get sufficient risk compensation—moreover, inflation itself is “heteroskedastic”: as inflation level rises, volatility increases, yet the market seems to underprice this risk.

Policy signals are contradictory; yield curve faces re-pricing risks

At the policy level, current market pricing logic has internal tension. White notes the market is enthusiastically revising up rate expectations.

Yet at the same time, the nominee most likely to be the next Fed Chair, Kevin Warsh, is not viewed as a strong hawk, while President Trump continues to pressure the current Fed Chair to cut rates immediately. These two signals contradict and are hard to coexist.

White warns that if market confidence in policy credibility falters, the ripple effects will go beyond just rate cut expectations, with both inflation expectations and term premiums forced higher; nominal yields may even rise across the board, rather than fall.

At that point, the yield curve could steepen—much like the 1973 post-Yom Kippur War OPEC oil crisis market moves, when the Fed under Arthur Burns, closely linked to the White House, paid a heavy price for damaged policy credibility.

"Inflation will eventually make its presence heard in the market one way or another," White writes. "Just don't think the long-end breakeven rate is the right place to listen."

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