Treasury market’s next test: rising war costs

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 totting up the tab for extended war-related defense 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% so far in the first quarter.

BNP Paribas, for instance, expects the US deficit to stay just below 6% of GDP over 2026 and 2027. Factor in the added costs, however, and “you get from a deficit that’s just below 6% to something that could easily be closer to 8% 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% 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 USD 39 trillion, and annual net interest payments are expected to reach USD 1 trillion this fiscal year.

The Pentagon is seeking more than USD 200 billion in supplemental funding from Congress for the Iran war, which is on top of the roughly USD 900 billion defense 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 USD 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 ton 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%, up from a recent 4.95%, “would be a big problem” and could prompt the government to cut long-dated issuance in favor 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.

(Reporting by Karen Brettell; additional reporting by Vidya Ranganathan; editing by Colin Barr and Anna Driver)