Iran War Pushes Up Oil Prices, Yet Market "Ignores Inflation"? Analysts Warn: TIPS Liquidity Premium Masks True Risks

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

The moderate upward movement of breakeven inflation rates is being masked by changes in liquidity premiums in the TIPS market. White’s analysis shows that, after removing the distortions caused by liquidity premiums, the market’s implied inflation expectations have hardly increased in reality, with some indicators even declining after the war broke out.

This indicates that the market is repeating the judgment made after the COVID-19 pandemic and the Russia-Ukraine conflict—that “inflation is only temporary”—a view that has previously been proven wrong.

Meanwhile, the rapid rise in interest rate expectations, the compression of term premiums, and the policy signals from the potential new Federal Reserve chair all form an internally contradictory market logic.

White warns that once policy credibility is damaged, both nominal yields and term premiums could be forced to reprice, with impacts far exceeding current market expectations.

Limited Rise in Breakeven Rates, “Temporary” Theory Resurges

Since the outbreak of the Iran war, the increase in U.S. inflation breakeven rates has been much lower than comparable historical events. The 2- to 5-year breakeven rates have risen about 20 to 35 basis points, while the 10-year breakeven rate’s increase is less than 10 basis points.

In comparison, after the Russia-Ukraine conflict in 2022, the 10-year breakeven rate once spiked nearly 100 basis points. Despite higher spot inflation levels at that time, the market’s reaction was still significantly more subdued than historical benchmarks.

White points out that the market’s “muscle memory” is at work—after testing through the pandemic and Russia-Ukraine conflict, the core belief that “inflation is only temporary” remains deeply ingrained. Investors generally expect the energy price shock to have only a short-lived impact on CPI.

Liquidity Premium Dilutes Inflation Signals, Real Expectations May Be Lower

However, breakeven rates are not precise measures of inflation expectations. White explains that breakeven rates essentially equal inflation expectations minus TIPS liquidity premiums. When liquidity premiums decline, even if inflation expectations stay unchanged, breakeven rates will rise accordingly, potentially misleading the market.

Crude oil prices have historically been one of the most recognized real-time inflation indicators. During oil shocks, investor demand for TIPS often rises quickly, lowering liquidity premiums, which is the main driver of TIPS pricing in the early stages of oil price shocks.

White used the Fed’s historical series of 5-year TIPS liquidity premiums, estimated via the DKW model, and regressed it against oil prices. The results show that since the war’s outbreak, the liquidity premium has fallen about 20 basis points—roughly matching the increase in the 5-year breakeven rate.

In other words, the rise in breakeven rates is largely, if not entirely, offset by the decline in liquidity premiums. The market’s implied underlying inflation expectations may have hardly moved or even declined.

Another approach—examining the spread between inflation swaps and breakeven rates (which do not require asset-liability commitments and have smaller liquidity premiums)—yields similar conclusions: large oil price surges have historically been accompanied by declines in TIPS liquidity premiums, and this time is no exception.

Real Yield Rise Is Contradictory; Concerns Over Term Premium Compression

Why are real yields still rising? White believes this is mainly due to market expectations of higher policy rates, rather than improvements in economic growth prospects— which should be under pressure during an oil shock.

Another concern is that the upward potential of the term premium is significantly compressed. In the composition of nominal yields, the contribution of the term premium is relatively limited, which could itself be a dangerous complacency.

White points out that the term premium can be further decomposed into inflation expectations, inflation term premium, and real term premium.

If long-term inflation expectations do not materially rise, the inflation term premium will also struggle to receive adequate risk compensation—moreover, inflation itself is heteroskedastic, meaning its volatility increases with rising inflation levels, which the market seems to be underpricing.

Conflicting Policy Signals and Repricing Risks in the Yield Curve

On the policy front, the current market pricing logic also contains internal tensions. White notes that the market is eager to raise rate expectations.

But at the same time, Kevin Warsh, a leading nominee for Fed Chair, is not seen as a hawkish figure, and President Trump continues to pressure the current Fed Chair to cut rates immediately. These signals are contradictory and hard to reconcile.

White warns that if market confidence in policy credibility wavers, the chain reaction will go beyond just rate cuts. Inflation expectations and the term premium will be forced to upwardly reprice together, and nominal yields could rise overall rather than fall.

This could lead to a steepening of the yield curve—similar to the market behavior after the 1973 “Yom Kippur War” and the first OPEC oil crisis, when the Fed under Arthur Burns, closely tied to the White House, suffered heavy costs due to eroded policy credibility.

“Inflation will eventually make its voice heard in some way,” White writes, “but don’t assume the long end of the breakeven curve is the right place to listen.”