BofA: Rates Could Jump 'Significantly Higher' If Oil Keeps Climbing

Oil prices climbing over the next 3-6 months could push interest rates "significantly higher," according to Bank of America strategists Ralph Axel and Oliver Levingston — even if the Iran war ends.

The two strategists found that rates and oil have been dramatically correlated over the past few decades across the U.S., the U.K. and Germany. "If oil prices continue to rise over the next 3-6 months, we could see significantly higher interest rates," they said.

The U.S. numbers make the point sharply. The yield on the 2-year Treasury is up 111 basis points since the start of the year. But break the year into trading days and the pattern tightens: on days when oil prices rose, the 2-year yield climbed by about 196 basis points; on other days, it fell by 83 basis points. In the U.K. and Germany, the strategists said, the effect has generally been even starker.

Why does the front end matter most? "If oil prices rise, we think rates will too, especially at the front end where long-end term premium is less of a factor and monetary policy expectations play a larger role," Axel and Levingston wrote in a Thursday note.

What's the transmission mechanism?

The strategists laid out a familiar sequence:

• Spiking energy prices lead to higher bond yields as investors demand greater compensation.
• Central bank governors walk into policy meetings with increased projections of hikes.
• They eventually deliver on those expectations.

The Federal Reserve, they argue, would likely face fewer challenges than other central banks if it enters a tightening cycle, thanks to robust consumer spending, stronger-than-expected GDP growth and a resilient U.S. labor market.

Oil futures now sit significantly lower than before Tuesday's midterm elections, as markets increasingly price in the Iran war ending sooner rather than later. But the strategists aren't ruling out further rises, especially if the conflicts in the Middle East or Ukraine intensify.

"While the evolution of geopolitical conflict is impossible to predict — the course of the Ukraine-Russia war serves as an example of how surprisingly long such conflicts can last," Axel and Levingston wrote. "Even if the Iran conflict ended soon or settled down greatly, we cannot be assured that crude supply from the Gulf would reliably resume to its pre-war rate or that Ukraine would cease to hit Russian refineries."

The trade: pay fixed on the 2-year

Based on the rates-oil relationship, the strategists advised a pay-fixed position in U.S. two-year rates. Their reasoning: they don't see the Fed pushing against market expectations of hikes heading into meetings.

"With a new Fed Chair who has yet to establish strong credibility in the inflation fight, we think holding rates in meetings with over 50% chance of a hike priced could wind up losing control of long-end rates," they wrote.

What does this change for practitioners? If BofA is right, the trade isn't about betting on the war's duration — it's about oil's trajectory and the Fed's credibility gap. A new chair reluctant to validate priced-in hikes could let the long end run, which is exactly why the strategists want to be paying fixed at the front end now rather than waiting for confirmation.