The influence of supply and demand.

Last week offered a lesson in supply and demand, along with a reminder that financial markets are always looking to the future. As disruptions in the Middle East squeezed oil supplies, rising fuel prices and August inflation data seemed to set the stage for higher interest rates and lower stock prices. Then, Friday’s news that demand for oil may be weakening changed the outlook, and stock markets found a bit of relief.

Here are some highlights from last week:

• There was an oil supply shock. Conflict in the Middle East expanded, further reducing the availability of oil. “For Middle Eastern oil producers, there are fewer and fewer places to hide from Iranian violence. And because of that, oil prices are almost certain to stay high,” reported Avi Salzman of Barron’s.
• Falling supply pushed fuel prices higher, pressuring inflation. Diesel fuel reached an all-time high of $6.00 a gallon, up from $3.70 a year ago. Diesel is required for “around 70 percent of the movements of freight, rail, agriculture, and construction equipment, and is a key component of domestic inflation when prices rise,” reported Callum Keown and Martin Baccardax of Barron’s.
• Higher inflation changed the interest rate outlook. Consumer and Producer Price readings for August arrived last week, showing inflation remained high. As investors considered the possible impact of higher oil prices, the chance of a Fed rate hike in September climbed above 85 percent, according to CME FedWatch. In response, the 10-year Treasury yield approached 5 percent.
• The forecast for oil demand changed. On Friday, the International Energy Agency (IEA) Oil Market Report forecast that global demand for oil will fall more sharply than expected in the latter half of 2026 because of higher prices and economic disruptions.

Markets welcomed the possibility that weaker demand for oil could eventually ease oil prices and inflation pressures. After four days of declines, stock markets rallied on Friday.

The supply problem, however, has not gone away. The IEA expects oil supply to fall even faster than demand, while global inventories are being rapidly depleted. In other words, Friday’s rally did not indicate the oil shock is over. It reflected a change in the outlook, and a reminder that markets care about where prices are today, and where they may be headed tomorrow.

Last week, major U.S. stock indexes finished the week lower, despite advancing on Friday. Yields on U.S. Treasuries moved higher across the yield curve.

S&P 500, Dow Jones Global ex-US, S&P GSCI Gold Index, Bloomberg Commodity Index returns exclude reinvested dividends. The three-, five-, and 10-year returns are annualized; and the 10-year Treasury Note is simply the yield at the close of the day on each of the historical time periods. 

Sources: Yahoo! Finance; MarketWatch; djindexes.com; U.S. Treasury.

Past performance is no guarantee of future results. Indices are unmanaged and cannot be invested into directly. N/A means not applicable.

HERE’S HOW A BOND WORKS. A bond is a loan. When investors buy U.S. Treasury bonds, they agree to lend their money to the government for a specific period of time. In return, the government agrees to pay interest for that period and return the amount borrowed when the bond matures. In the interim, Treasury bond rates may move higher or lower. The market value of the Treasury, which is the value an investor receives if they sell the bond before maturity, will change to reflect current rates.

How do rates affect bond prices?

There is a question about this on FINRA’s financial literacy quiz that stumps a lot of people every year. It asks: If interest rates rise, what will typically happen to bond prices?

1. They rise.
2. They fall.
3. They stay the same.
4. Nothing. There is no relationship between interest rates and bond prices.

The correct answer is that bond prices fall when rates rise.

There is an inverse relationship between bond prices and interest rates

Imagine that a fictional investor, Chris, buys a 10-year U.S. Treasury for $1,000. It pays 4 percent interest. After a few months, interest rates rise. Newly issued 10-year Treasuries offer 5 percent interest. Chris can hold the bond to maturity (and continue to receive 4 percent interest) or sell it. If Chris sells, the bond will be worth less than the amount originally paid because new bonds have higher rates.

It works the other way, too. Imagine that after Chris buys the bond, interest rates fall, 10-year U.S. Treasuries now pay 3 percent interest. Chris can hold the bond (and receive 4 percent interest until maturity) or can sell the bond. It will be worth more than Chris paid because new bonds have lower rates.

It may help to think of bonds as a seesaw. At one end are bond prices, at the other are interest rates. As one falls, the other rises. If you have questions about bonds, please get in touch.

WEEKLY FOCUS – THINK ABOUT IT

"Where there is great love, there are always miracles."

—Willa Cather, Author