What's really got the U.S. stock market spooked about this latest geopolitical conflict

Oil prices rose. The U.S. dollar turned higher. These moves are par for the course after a geopolitical event such as the joint U.S.-Israeli attacks against Iran. The reaction in Treasurys, however, have global investors scratching their heads. The benchmark 10-year Treasury note yield has shot up more than 14 basis points this week already, to around 4.1%. It ended last week at 3.94%. The shorter-term 2-year note yield that’s the most sensitive to expectations of Federal Reserve policy, has seen a bigger jump, soaring nearly 20 basis points to 3.53%. Those moves are unusual because, historically, investors have turned to Treasurys in uncertain times. U.S. Treasurys are considered to be one of the safest investments in the world. (Yields move inversely to prices, so when yields are rising, prices are falling). US2Y 5D mountain US 2-year Treasury yield 5-day chart But the surge in energy prices, including a troubling jump in natural gas prices in the U.S. and abroad, came at a fragile time. “The conflict in the Middle East is defining the macro narrative at the moment, with energy prices surging higher yet again,” wrote Ian Lyngen head of U.S. rates strategy at BMO. “The rise in real rates isn’t the only aspect of this week’s price action that has fallen outside of the ‘typical’ response to military escalation in the Middle East. The flattening of the yield curve also caught us offsides.” So why is the bond market behaving in such a weird way? The answer is inflation. Inflation had been trending lower in the U.S., raising expectations that the Federal Reserve would trim its overnight lending rate later this year. Two reports poured cold water on those hopes. On Friday, the producer price index rose 0.8% in January , much more than expected. On Monday, the Institute for Supply Management reported a massive spike in its manufacturing prices index . Because of this, fed funds futures traders have lowered rate cut expectations. The CME Group’s FedWatch tool shows a 63% chance that the Fed will keep rates unchanged at its June meeting. That’s up from 54% one day ago. Odds of no rate cuts in July also rose, to 45% from 36.8%. “U.S. Treasuries are likely to follow energy prices,” wrote Gregory Faranello, head of U.S. rates at AmeriVet Securities. “The Fed will view this as a ‘shock’ to the system but [it] will sideline them, nonetheless. And they were already on hold.”