The next test for the U.S. bond market: Rising costs of war

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The inflation shock triggered by the Iran war has pushed up U.S. Treasury yields, and as the possibility of continued conflict increases, the bond market is facing another threat—a persistently climbing fiscal cost of war.

Analysts warn that if extended war-related defense spending, tariff refunds, and potential economic stimulus measures are all factored in, the U.S. fiscal deficit may jump from nearly 6% of GDP to 8% or even higher. This outlook poses new risks for the already pressured bond market—S&P's U.S. Aggregate Bond Index has already fallen 0.6% in the first quarter this year.

Currently, mainstream Wall Street expectations still lean toward a short-term end to the conflict, believing oil prices and fiscal pressures will ease accordingly. However, some analysts point out that the market has not fully priced in potential fiscal risks, and once actual legislation is enacted, the bond market's reaction could be much more dramatic.

Fiscal Gap May Expand Sharply, Yield Curve Already Shows Signs of Pressure

America's fiscal status was already quite fragile before it launched its first strike against Iran on February 28 this year. National debt has reached a record $39 trillion, and net interest payments this fiscal year are expected to exceed $1 trillion.

War spending has further intensified this pressure. The Pentagon is requesting over $200 billion in Iran war supplemental funding from Congress, atop the roughly $900 billion FY2026 defense budget already signed. Meanwhile, the Supreme Court has ruled that the President cannot impose tariffs under emergency powers, which may force the government to refund about $175 billion to importers. Though authorities claim they will levy alternative tariffs based on other legal authorizations, whether this can fill the revenue gap remains uncertain.

Andrew Husby, Senior Economist at BNP Paribas, says that considering these factors, the U.S. deficit "could easily rise from nearly 6% to nearly 8% or even higher," a trajectory bond investors do not want to see.

Selling pressure in the bond market is currently concentrated at the short end, reflecting cooling expectations for near-term Fed rate cuts. But long-term yields are rising as well, with the 10-year Treasury yield approaching 4.5% this month, the first time since last summer, with parts of debt auctions also showing weak demand.

Bill Campbell, portfolio manager at DoubleLine Capital, states, "All these small costs seem to keep accumulating." He warns that if the 30-year Treasury yield rises from the recent 4.95% to 5.25%, "it will be a big problem," possibly prompting the Treasury Department to reduce long-term bond issuance and increase short-term Treasury supply instead.

Market Has Not Fully Priced in Fiscal Risks

Despite clear warning signals, the market has not significantly repriced U.S. fiscal prospects. Andrew Husby points out that the market may be waiting for actual legislation to take shape before reacting more strongly. "Currently, not much extra fiscal risk is truly priced in."

Dirk Willer, Citi's Head of Macro and Asset Allocation Strategy, believes the biggest risk is: if inflation persists, the Fed cannot cut rates, and fiscal spending expands simultaneously, coupled with the Fed possibly shrinking its balance sheet, then "the voice of fiscal factors may return to a greater degree," producing more significant shocks to the bond market.

Analysts note that compared to long-term fiscal concerns, more urgent threats stem from the Fed’s possible shift to rate hikes and the continued escalation of geopolitical risks.

Robert Tipp, Chief Investment Strategist and Head of Global Bonds at PGIM Fixed Income, warns that "the other shoe dropping" scenario would be: if economic growth persists and inflation remains high, the Fed may be inclined to raise rates this year or even actually hike.

Christian Hoffmann, Head of Fixed Income at Thornburg Investment Management, observes that over the years, geopolitical shocks have ultimately proven manageable, training investors into an inertia of underestimating risks. "We may now be at the tipping point where this pattern is broken."

Meanwhile, Mike Cudzil, Portfolio Manager at PIMCO, maintains a relatively optimistic stance, believing that oil price shocks will ultimately drag down economic growth, thus preventing rate hikes and creating room for the Fed to cut rates later this year, which will help push yields lower. Based on this judgment, PIMCO has increased holdings of long-term bonds in several developed markets.

Risk Warning and DisclaimerThe market carries risk, and investing requires caution. This article does not constitute personal investment advice, nor does it consider individual users' specific investment goals, financial situations, or needs. Users should consider whether any opinions, views, or conclusions in this article are suitable for their particular circumstances. Investments made accordingly are at your own risk. ```