The myth of U.S. Treasuries as a safe haven is quietly being shaken amid war and massive deficits.

The safe-haven demand triggered by the Iran conflict has not pushed funds into US Treasuries as it did in the past. On the contrary, the inflation shock brought by war combined with the structural expansion of the US fiscal deficit is weakening the hedging efficiency of US Treasuries as the global “safe-haven asset”.

According to The Wall Street Journal, the US stock market still closed slightly higher on Monday, continuing the market’s usual "buy-the-dip" inertia in the wake of sudden negative news. However, the bond market performed poorly—yields on both short and long-term US Treasuries have continued to rise since the market opened on Monday, indicating that Treasuries have failed to provide the traditional buffer under stress scenarios.

The volatility of risk assets was first concentrated overseas. Korea’s main stock index, the best performing in the world last year with a cumulative gain of 92%, saw its biggest overnight drop since 2008 due to worries about the spillover effects of war on the economy. US stock index futures once plunged sharply, but turned positive before opening.

Factors driving US Treasuries down, besides concerns about renewed inflation due to rising oil prices, also include the continued squeeze on US fiscal space. Last month, the US Congressional Budget Office raised its 10-year deficit forecast by $1.4 trillion, prompting investors to re-evaluate the boundaries of “risk-free” pricing.

Safe-haven logic challenged, Treasuries fail as "shock absorber"

The core reason investors are willing to accept lower returns to hold US Treasuries is that they usually serve as a “shock absorber” during risk events. In a typical scenario, if the stock market falls 10%, as long as bonds rise about 3%, losses for a classic 60/40 stock-bond portfolio can be kept within 5%.

But this time, bonds did not rise as expected. Long-term US Treasury ETFs fell 1% on Monday and continued to drop on Tuesday, while the stock market only began to fully price in the possibility of extended conflict afterward. This "stocks holding up while bonds fall first" combination challenges the hedging logic itself.

Oil prices push inflation higher, central banks find it harder to cut rates

Continued increases in oil prices will push up inflation, prompting investors to demand higher yields, which in turn depresses bond prices. Even if the energy shock may drag on growth and traditionally bring expectations of rate cuts, policymakers may respond more cautiously.

According to The Wall Street Journal, due to fears of repeating the stagflation of the 1970s, central banks might be reluctant to cut rates easily in response to an energy shock.

This contrasts with the typical reaction after non-energy shocks, such as the clear rebound in bonds historically following events like 9/11, the Lehman Brothers collapse, and Brexit. However, during the Iraqi invasion of Kuwait in 1990, when oil prices soared and triggered a recession, bond prices also faced pressure early on.

High deficit intensifies bond market vulnerability

Oil prices may not be the only variable. The US fiscal situation is already "maxed out": last month, the US Congressional Budget Office raised its 10-year deficit forecast by $1.4 trillion. The federal deficit as a proportion of economic output has reached a rare high in non-recession periods since World War II.

At the same time, the scale of US debt held by the public is about to cross the threshold set during World War II. In that era, “the public” mainly referred to domestic savers in the US; nowadays, overseas creditors from the Middle East and Asia hold a considerable share of US Treasuries and may worry about the impact of conflicts on their own economies.

In this structure, US Treasuries need to demonstrate their appeal to global capital, and sensitivity to interest rates and exchange rates also rises as a result.

Historical lessons: Rising yields in Vietnam War, WWII’s “suppressed rates” hard to replicate

Historical experience suggests that the combination of war and fiscal expansion does not always benefit Treasuries. Even during the Vietnam War, when the US depended less on overseas financing, bond yields rose as Washington pursued both the “war on poverty” and the real war.

During World War II, the key reason Treasury yields remained subdued, according to The Wall Street Journal, was that the Treasury and Federal Reserve worked together to "push down" yields, at the expense of diluting savers’ returns.

But in an era of free capital flow, if markets worry about a return to "fiscal dominance," it could trigger investor anxiety and weigh on the dollar.

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