Inflationary pressures have pushed U.S. Treasury yields higher since the clash with Iran ignited energy prices. Now, another challenge is emerging for the bond market: the fiscal burden of a drawn-out conflict. Wall Street continues to anticipate a short-lived war, which would ease pressure on oil prices and U.S. finances. Yet analysts are already calculating the potential costs of extended military spending, tariff refunds, and economic stimulus if growth slows sharply. These additional expenses could weigh on a bond market that has recently been less friendly, as reflected in the S&P U.S. Aggregate Bond Index, which has returned negative 0.6% so far in the first quarter. BNP Paribas projects that the U.S. deficit will remain just below 6% of GDP in 2026 and 2027, but factoring in war-related costs could push it closer to 8%, according to senior economist Andrew Husby. Such a trajectory would be unwelcome news for bond investors.
Short- and Long-Term Yields Under Pressure
The most intense selling has concentrated on short-term yields, reflecting diminishing hopes for near-term Federal Reserve rate cuts. However, longer-dated yields have also risen, with the 10-year Treasury briefly approaching 4.5% for the first time since last summer, and recent Treasury auctions showing weak demand. Portfolio manager Bill Campbell of DoubleLine Capital noted that “all of these little costs seem to be adding up.”
Record Debt and Rising Defense Spending
The U.S. fiscal position was already stretched before the first strike on Iran on February 28. The national debt has reached a record $39 trillion, with annual net interest payments projected at $1 trillion this fiscal year. The Pentagon is seeking more than $200 billion in supplemental funding for the Iran conflict, in addition to the roughly $900 billion defense budget already approved for fiscal year 2026. Revenue has also been affected by a Supreme Court ruling that restricts the president from using emergency powers to impose tariffs, potentially necessitating $175 billion in refunds to importers, though replacement tariffs may partially offset the losses.
Markets So Far Unfazed
So far, markets are not pricing in major fiscal shifts. Husby of BNP Paribas said investors may wait for concrete legislation before reacting, while Dirk Willer of Citigroup highlighted the risk that the Fed could be unable to cut rates amid rising fiscal spending and potential balance sheet reductions. Such conditions could amplify fiscal pressures in the bond market.
Near-Term Risks: Fed and Geopolitics
Near-term risks remain focused on potential Fed rate hikes and escalating geopolitical tensions. Robert Tipp of PGIM Fixed Income warned that if growth continues and inflation remains elevated, the Fed may adopt a tighter stance, further pressuring yields. Christian Hoffmann of Thornburg Investment Management observed that years of geopolitical shocks that proved manageable have trained investors to underreact a pattern that may persist until it is broken.
Potential Treasury Responses and Opportunities
If long-term yields continue to climb, the Treasury might adjust its issuance strategy. Campbell suggested that a 30-year yield rising to 5.25%, from a recent 4.95%, could prompt a shift from long-dated debt to short-term bills. On the other hand, Mike Cudzil of PIMCO expects the oil shock to eventually slow growth, potentially allowing the Fed to cut rates later this year, which could reduce yields and create opportunities in longer-dated debt across developed markets.
With information from Reuters.
