The war came home for America this week.

Not in the form of any actual fighting, but rather as violence at the front-end of the Treasury curve.

Forgetting Friday’s prevaricating, two-year yields rose ~20bps against just ~12bps for 10s on out, bear flattening the curve.

Headed into the week’s final session, twos were cheaper by almost 40bps for March.

As the figure shows, that’s the most pronounced nine-session selloff in 10 months. That it’s playing out against one of the most acute bouts of oil volatility on record is no coincidence.

In simple terms: The sharp run up in crude is forcing markets to rethink and reprice short-end rates in light of the possible monetary policy implications from a prolonged energy supply shock.

While it’s true that central banks can’t address supply shocks (or at least not in a direct, systematic way), they nevertheless have to incorporate them into the decision calculus, lest monetary policy should inadvertently make a bad situation worse.

Officials are especially sensitive to that risk now, having spent the better part of three years course correcting after leaving policy too loose for too long in the face of modern history’s biggest negative supply shock (i.e., the pandemic).

As BMO’s Vail Hartman and Ian Lyngen noted this week, twos are now at (and on Thursday, through) IORB. The figure below gives you some context.

Why does that matter? It’s about the implication. “[Forgetting] term premium nuance, pricing two-year rates here effectively implies that the average expected overnight rate over the next 24 months will match the current policy rate,” Hartman said, calling that “a low likelihood scenario” given the dot plot’s bias for cuts, but also the “high bar for an oil supply shock to derail the disinflation trend in core PCE.”

The crux of the issue is whether the front-end is too worried about the read-through of oil-driven inflation on monetary policy and not worried enough about the implications of a sustained energy price crunch for aggregate demand (i.e., consumer spending).

If you ask BMO’s US rates team, current front-end pricing suggests markets are underestimating the negative read-across to spending. “We believe the market is underweighting the risk that higher energy prices lead to a drop-off in demand,” they said. “Particularly given the fragility of the labor market and a consumer that had already been under pressure before the recent surge in gas prices.”

I tend to agree, but here’s the thing: What you’re seeing in front-end rates isn’t all rational markets doing their “efficient” thing. Rather, consensus expectations for monetary policy were wrong-footed by the surge in oil prices, and once that trade moved too far in the “wrong” direction, trend strats bailed as key trigger levels were breached and lopsided bets were stopped out.

The figures above show you what that dynamic looks like for CTAs in STIRs (left) and across G10 bonds (right). Note the annotations from Nomura’s Charlie McElligott, particularly on the right-hand chart where he emphasizes that most of the deleveraging shown by the dashed red arrow was at the front-end.

“The pain trade has been obvious in March,” Hartman went on, commenting on the mechanical aspect of the front-end selloff. “Forced de-risking and de-leveraging has exacerbated the selling pressure.”

Weighing in Friday, McElligott wrote that USD rates vol has “finally caught the bullwhip” from the European front-end, which you’ll recall was “patient zero.”

“The renewed bid to crude began to ‘pucker’ some folks stateside, with military actions now seemingly being repriced to reflect something that’s no longer done in ‘weeks,’ but instead could last many months,” Charlie said.

“If this repricing higher of USD rate vol were to proliferate, it’s very likely that US stocks are finally gonna ‘wear it’ too,” McElligott added, noting that a persistent bid for front-end rate vol would be tantamount to traders asserting not only that the Fed may be unable to cut to offset slower hiring and address still-simmering credit concerns, “but could in fact even hike.”