Inflation or recession? The U.S. bond market is caught in a dilemma!

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The U.S. Treasury market is experiencing a battle of direction: Is the Middle East war an inflation threat, or a drag on growth? As the market narrative quietly shifts, this question is putting bond traders in a dilemma.

On Tuesday, the U.S. extended its rebound, with the two-year yield edging lower and the ten-year yield falling significantly from last week's eight-month high. Market sentiment has subtly shifted—investors are increasingly interpreting the Middle East conflict as a global growth downside risk rather than simply as inflationary pressure, with renewed safe-haven demand supporting U.S. Treasuries. Meanwhile, oil prices saw wild swings during the day, further adding to market uncertainty.

However, this shift does not mean the direction is clear. The core dilemma for traders is: The war is driving both inflation expectations higher and increasing the risk of recession—these forces pull in opposite directions, making it difficult for the market to reach a consensus judgment and making the Federal Reserve’s policy path even murkier.

Market narrative shifts, safe-haven logic takes over again

U.S. Treasuries rose for a second straight day on Tuesday. The two-year yield dipped by 1 basis point to 3.82%, having dropped 8 basis points the previous day; the ten-year yield fell by 2 basis points to 4.33%, down noticeably from last week’s eight-month high of 4.48%.

Nevertheless, since the outbreak of the war, the two-year yield has still risen more than 40 basis points in total, and is on track for its biggest monthly gain since October 2024, showing the market’s pricing for inflationary pressures has not fully dissipated.

Andrew Ticehurst, Senior Strategist at Nomura Australia, said: "In the past few days, we have seen a change in market thinking. Initially, the market focused on the inflationary impact of the Middle East conflict, but I believe now the market is starting to consider more the downside risk to growth."

Sharon Bell, Senior European Equity Strategist at Goldman Sachs, told Bloomberg TV that even if the conflict ends quickly, the negative economic impact of a war with Iran will still linger.

Wild swings in oil prices heighten market disagreement

Oil prices fluctuated strongly on Tuesday, becoming a major source of market volatility for the day. Oil prices surged intraday after reports that an Iranian drone hit a Kuwaiti oil tanker near Dubai, but pared gains after the Wall Street Journal reported that Trump had told advisers he would be willing to end military action against Iran even if most of the Strait of Hormuz remained closed.

These reports highlight huge uncertainty about the outlook for energy supply. The Strait of Hormuz is a globally significant oil shipping route, and its accessibility directly impacts global energy prices, tipping the balance between inflation and growth expectations.

Stagflation dilemma, unclear policy path

The deeper contradiction facing the market now is that the war has triggered both inflation and recession risks—two opposing forces that leave little room for policy response.

Win Thin, Chief Economist at Nassau 1982 Bank, said bluntly: "The market is oscillating between inflation panic—rising yields—and growth slowdown panic—falling yields. This is exactly the problem of stagflation: there is no simple policy solution, so the market finds it hard to decide whether to focus on 'stag' or 'flation'."

Currently, traders bet that the Federal Reserve will keep rates steady in the 3.5%-3.75% range this year, with only a small odds of a single 25-basis-point rate cut before mid-2027.

Fed Chair Jerome Powell said on Monday that long-term inflation expectations still appear anchored, but that the Fed is closely monitoring the impact of the war. Fed Vice Chair for Supervision Michelle Bowman and Governor Michael Barr are scheduled to speak Tuesday evening, with markets looking for more rate path clues.

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