Middle East conflict triggers global "deficit panic": 30-year U.S. Treasury yield approaches 4.9%, all bond market gains this year have been wiped out!

Concerns over fiscal spending triggered by the US-Iran war are sweeping the global bond market, with long-term government bonds facing a new round of selloffs.

On Friday, the 30-year US Treasury yield climbed to nearly 4.90%, marking a nearly one-month high. Since the outbreak of war on February 28, this yield has risen over 20 basis points, erasing all gains in US Treasuries so far this year. Bloomberg's index tracking US Treasury returns is now nearly zero for the year.

This selloff is not limited to the United States. From the UK to Germany, from Australia to Japan, global bond yields are soaring across the board, and long-term government bonds are generally under pressure.

Investors worry that as war costs continue to rise, governments worldwide will have to borrow heavily to fund defense spending and subsidize households affected by energy price shocks. This outlook, combined with inflationary pressures from rising oil prices, poses a dual threat to the fixed income market.

Dual Pressure from Fiscal and Inflation Squeezes Long-Term Rates

This rise in long-term yields is driven by both inflation expectations and fiscal deterioration concerns.

Notably, the yield on 30-year Treasury Inflation-Protected Securities (TIPS) rose 7 basis points this week—while short-term real interest rates fell due to expectations of slower growth. This divergence suggests that market concerns about the long-term sustainability of public finances go beyond the economic cycle alone.

"Long-term rates are a fiscal story and a story of government credibility," said Gang Hu, managing partner at Winshore Capital Partners. "They reflect market expectations that Trump will need to spend for the war, and subsidize consumers facing high oil prices."

The US Congress is currently discussing up to $50 billion in extra war appropriations, but the government has not yet released specific cost estimates for military actions. Meanwhile, the US budget deficit reached about $1 trillion in the five months ending in February, and a Supreme Court ruling overturning tariff judgments abruptly removed a source that could have contributed tens of billions of dollars to the government.

"This is happening at a time of reversal in tariff income, and tariffs themselves are inflationary, as is war," said Matt Eagan, portfolio manager at Loomis, Sayles & Co., which manages over $430 billion in assets. "This will only make the deficit worse."

Thursday's $22 billion auction of 30-year US Treasuries saw decent demand after yields surged, but market analysts remain pessimistic about the outlook. "I don't see any appeal in 30-year Treasuries until yields break above 5%," Eagan added.

Global Wave of Borrowing, Bond Market Pressure Spreads Outwards

Fiscal pressures are not confined to the US. In Europe, governments face dual pressures from higher defense spending and potential energy subsidies. European Commission President Ursula von der Leyen this week proposed several measures in response, including a cap on gas prices. According to Nomura senior European economist Andrzej Szczepaniak, European governments may replicate their response to the 2022 energy crisis by issuing joint EU bonds to finance crisis spending, which will put structural pressure on eurozone bond markets.

Asia is also finding it hard to remain unaffected. Australia, Singapore, and other countries have successively increased defense budgets, and Japan's defense spending is expected to set a new record this year. Commonwealth Bank of Australia strategist Carol Kong pointed out that the Iran conflict could further intensify long-term spending pressure for Asian governments, making fiscal consolidation more complex, "Rising inflation expectations will also push bond yields higher, and Asia, including Japan, is no exception."

Chris Arcari, head of capital markets at Hymans Robertson, noted that compared to the energy crisis triggered by the Russia-Ukraine conflict in 2022, governments now have more limited fiscal space, with both debt burdens and interest costs higher. The bond market may be less willing to finance such large-scale fiscal expansion this time, at least demanding higher real yields as compensation.

Investors generally believe that if the conflict continues and governments worldwide ramp up spending, the ongoing expansion of global sovereign debt supply will keep long-term yields under pressure, and demanding a higher risk premium for long-term bonds will become the new normal in the market.

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