Inflation risks have driven Treasury yields higher since the US clash with Iran ignited energy prices. Now another threat to bond market health is coming into view: the cost of an extended conflict.
Wall Street continues to expect the war to end soon, easing pressure on both the price of oil and the US purse. Even so, some analysts are toting up the tab for extended war-related defence spending, tariff refunds and a potential stimulus should the economy slow sharply. They say it could become an issue for markets that have recently become less friendly to bonds, with the S&P US Aggregate Bond Index returning -0.6 per cent so far in the first quarter.
BNP Paribas, for instance, expects the US deficit to stay just below 6.0 per cent of GDP over 2026 and 2027. Factor in the added costs, however, and “you get from a deficit that’s just below 6.0 per cent to something that could easily be closer to 8.0 per cent or even a bit above,” said senior economist Andrew Husby. That isn’t a trend bond investors want to see.
SIGNS OF INFLATION STRESS
The most intense bond market selling has so far been concentrated in short-term yields, reflecting fading hopes for near-term Federal Reserve rate cuts. But longer-dated yields have also climbed, with the 10-year Treasury briefly nearing 4.5 per cent for the first time since last summer and some Treasury auctions this month drawing weak demand.
“All of these little costs seem to be adding up,” said Bill Campbell, a portfolio manager at DoubleLine Capital.
The US fiscal position was already stretched before the first US strike on Iran on February 28. The national debt has reached a record $39 trillion, and annual net interest payments are expected to reach $1 trillion this fiscal year.
The Pentagon is seeking more than $200 billion in supplemental funding from Congress for the Iran war, which is on top of the roughly $900 billion defence bill already signed for fiscal year 2026.
The government’s revenue position also took a hit after the Supreme Court ruled that the president cannot use emergency powers to impose tariffs, potentially requiring around $175 billion in refunds to importers. The administration has said it will impose replacement tariffs under separate legal authority, though it is unclear whether these will fully make up the lost revenue.
NOT LEADING MOVES SO FAR
Markets so far aren’t expecting large shifts in the US fiscal outlook.
BNP’s Husby said markets may simply wait for actual legislation to take shape before reacting more forcefully. “There’s not a tonne of extra fiscal risk really being priced right now,” he said.
Dirk Willer, head of macro and asset allocation strategy at Citigroup, said the biggest risk is that the Federal Reserve won’t be able to cut rates due to inflation while fiscal expenditures are rising and the Fed is potentially looking to cut the size of its balance sheet.
Then, “you could see again the fiscal voice coming back to a larger extent.”
FIRST THINGS FIRST
Nearer-term threats may be a Fed rate increase and rising geopolitical risk.
Robert Tipp, chief investment strategist and head of global bonds at PGIM Fixed Income, warned that “the other shoe to drop would occur if and as growth continues and inflation stays high and it turns out the US is going to have a hiking bias or hike rates this year”.
Christian Hoffmann, head of fixed income at Thornburg Investment Management, says years of geopolitical shocks that ultimately proved manageable have trained investors to underreact -- a pattern that will likely hold until something breaks it. “We might be at the cusp of that right now,” he said.
If longer-dated yields do continue to rise, the Treasury’s most likely response would be to alter its issuance strategy. Campbell of DoubleLine said a 30-year yield of 5.25 per cent, up from a recent 4.95 per cent, “would be a big problem” and could prompt the government to cut long-dated issuance in favour of short-term bills.
Mike Cudzil, a portfolio manager at PIMCO, sees the oil shock eventually slowing growth, forestalling rate hikes and potentially allowing the Fed to cut later this year -- sending yields lower. PIMCO has been adding longer-dated debt across developed markets on that basis.
