Oil Price Drop Eases Inflation Expectations, Triggers Rate Hike Reversal

The sharp decline in oil prices has brightened market sentiment and tempered expectations for a Federal Reserve rate hike. U.S. Treasury prices rose across the board on Tuesday, as signs of progress toward a diplomatic resolution to the Iran conflict triggered a significant drop in oil prices.

The two-year Treasury yield, the maturity most closely tied to Fed rate expectations, fell 4.56 basis points to 4.188%, its lowest level since July 20. Other yields also declined, with the five-year yield dropping 6.5 basis points to 4.32% and the 10-year yield declining 6.09 basis points to 4.613%.

A set of popular event contracts on Polymarket showed that traders' estimated probability of a 25-basis-point Fed rate hike in September had fallen to 48%, marking a rare drop below the 50% threshold. Short-term interest rate futures also indicate that markets are pricing in only about a 15-basis-point rate increase at the Fed's next policy meeting, significantly lower than earlier expectations.

The prediction market now appears to be once again ahead of the curve, with traders and investors awaiting Friday's release of the U.S. Bureau of Labor Statistics' July nonfarm payrolls report for clearer guidance on the path of interest rates.