Oil plunges 10% as US-Iran talks reshape rate outlook

US-Iran diplomatic progress pushed crude oil down nearly 10% this week, dragging Treasury yields lower for a third consecutive session as the slide in energy costs tempered inflation fears and reduced the odds of further Federal Reserve rate hikes.

"The precipitous drop in oil prices and May core PCE inflation coming in line with expectations led to a sharp decline in bond yields and a further flattening of the yield curve," Societe Generale rates strategists said in a note.

The 10-year Treasury yield fell 0.078 percentage point to 4.372%, while the 2-year dropped 0.090 point to 4.087%. Brent crude settled at $73.38 a barrel, down 2.5% on the day, and West Texas Intermediate slid to $70.11. The WSJ Dollar Index slipped 0.6% for the week, and the DXY fell 0.2% to 101.208.

The repricing reflects a market recalibrating to the prospect that easing geopolitical tensions could allow the Fed to hold rates steady at its July 28-29 meeting, even as the personal consumption expenditures gauge — the central bank's preferred inflation measure — remains well above its 2% target at a 4.1% annual rate.

The catalyst for the week's cross-asset moves was diplomatic progress between Washington and Tehran, which pushed Brent below $74 a barrel for the first time since before the conflict escalated. A US official said Iran was responsible for an attack on a Singapore-flagged cargo ship near the Strait of Hormuz, though markets focused on the broader trajectory toward normalization rather than the isolated incident. The strait handles about 21% of global oil trade, making any disruption a structural supply concern — and any resolution a powerful disinflationary force.

Money markets now price a 42% probability of one quarter-point rate increase this year, with odds of a second hike declining to 28% from 34% a week ago, according to CME's FedWatch tool. The shift lower in rate expectations came despite May core PCE printing at 3.4% annually, its highest since October 2023, and the all-items measure reaching 4.1% — both matching consensus estimates. The University of Michigan consumer sentiment index rose to 49.5 in June, slightly above the 49 consensus, as lower gasoline prices provided some relief to households. The Conference Board consumer confidence index, due Tuesday, is expected to rise to 94.6 from 93.1, according to a WSJ survey.

The yield curve bear-flattened, with short-term rates falling faster than long-term ones, a pattern that Muzinich & Co analysts said signals confidence in central banks' commitment to anchoring inflation but also warns of mid-to-late cycle economic risks. The last time oil prices fell this sharply in a single week — during the 2024 OPEC+ quota dispute — the 10-year yield dropped 0.12 point over the subsequent fortnight as inflation breakevens contracted. SEB chief strategist Jussi Hiljanen said the 10-year yield is likely to fluctuate in the 4.30% to 4.50% range in coming months, lacking a clear trend without additional support from macro data and Fed communication.

In Europe, the 10-year German Bund yield fell to a 3.5-month low of 2.841%, as lower oil prices prompted markets to scale back expectations for European Central Bank rate hikes. Money markets now price just over one additional quarter-point increase from the ECB, according to LSEG data, down from two hikes priced before the oil selloff began. BlueBay Asset Management's fixed income CIO Mark Dowding said shorter and intermediate maturities look more attractive than long-end bonds given expansionary fiscal policy, adding that two-year swaps at 2.75% are "attractively priced."

June payrolls data, due July 3, is forecast to slip to 118,000 from 172,000, according to a WSJ survey — a reading that could further shape the rate path if it signals labor market softening. The combination of falling energy costs, cooling labor demand and in-line inflation prints has given the Fed room to maintain its pause, even as new chairman Kevin Warsh has struck an increasingly hawkish tone on inflation.

This article is for informational purposes only and does not constitute investment advice.