Falling Every Day Amid Middle East Conflict: Why Treasuries are Faring Worse Than Risk Assets

Amid the flames of war in the Middle East, U.S. Treasuries—traditionally a safe-haven asset—currently appear to be performing even more poorly than risk assets like U.S. stocks.

 

Market data shows that while U.S. stocks staged a powerful rebound on Wednesday, the sell-off in U.S. Treasuries showed no signs of stopping. The 10-year Treasury yield, known as the "anchor of global asset pricing," climbed for a third consecutive session on Wednesday, rising 3.65 basis points to end at 4.096%. Bond yields move inversely to prices.

 

Looking at the trend so far this week, the U.S.-Israeli strikes on Iran have nearly ended a multi-week rally for U.S. Treasuries and pushed the 10-year yield back above 4%, a move that could drive up borrowing costs for businesses and consumers in the future.

 

 

While similar geopolitical conflicts in the past typically prompted investors to flee to the safety of bonds during stock market volatility, the "safe-haven halo" of Treasuries has clearly dimmed this time around.

 

In response, many bond traders noted that this is primarily because the conflict in the Middle East has simultaneously driven up energy prices. Currently, the impact of rising energy prices is more critical for investors, as it fuels fears of a resurgence in inflation, which in turn weighs on bond prices.

 

The current sell-off in Treasuries has disappointed many, as yields previously appeared poised to break below the bottom of their recent trading range. The 10-year yield has a significant impact on borrowing costs across the economy; its decline in February had pushed 30-year mortgage rates to a more than three-year low of under 6%.

 

Zach Griffiths, head of investment-grade debt and macro strategy at research firm CreditSights, pointed out, "The market is refocusing on the long-term implications of inflation, while the characteristics of typical safe-haven flows have weakened."

Inflation Threat Looms Over the Bond Market

For investors, the greatest threat of inflation is that it forces the Federal Reserve to raise short-term interest rates, or at least not cut them by as much as expected. Rising rates increase the attractiveness of alternative investment vehicles like money market funds, thereby eroding the value of intermediate and long-term Treasuries.

 

As things stand, the sharp rise in oil and gas prices is highly likely to push up the headline inflation index. Since the attack on Iran last weekend, international crude prices have risen cumulatively by about 12%, currently sitting at levels not seen since last June.

 

Although Fed officials typically focus on core inflation—which excludes volatile food and energy categories—a major energy price shock is undoubtedly another matter. Such shocks often bleed into other commodity prices and prompt businesses and consumers to expect inflation to remain high for years to come—an expectation economists warn could become a self-fulfilling prophecy.

 

Indeed, the Middle East conflict has pushed up certain market inflation expectation indicators this week. The gap between five-year nominal Treasury yields and five-year Treasury Inflation-Protected Securities (TIPS) yields—the so-called "break-even inflation rate"—has climbed from 2.46% last Friday to over 2.5%.

 

 

At the same time, investors have lowered their expectations for Fed rate cuts this year, with Fed funds futures showing the probability of two cuts falling from 79% last Friday to approximately 55%.

 

Even before the latest risks to the inflation outlook, the Fed was facing sticky price pressure from its preferred inflation gauge, the Core PCE Price Index. Based on estimates from January consumer and wholesale prices, the January Core PCE index is expected to show its largest month-on-month increase in a year when it is released next week.

 

Notably, when faced with new dual threats in the past, U.S. Treasuries have sometimes moved decisively in one direction only to reverse completely. A prominent example occurred last April following Trump's tariff announcements, where Treasuries initially rallied before falling sharply.

 

Currently, some investors remain bullish on U.S. Treasuries.

 

John Madziyire, head of U.S. Treasuries at Vanguard Group, stated his base case is that as the impact of tariffs fades and inflation eases, the Fed will resume rate cuts in the second half of the year, at which point long-term yields will test lower levels.

 

He also noted that if energy prices climb due to a prolonged Iran conflict, it could hinder the rate-cutting process, but such a move would also drag on economic growth, prompting investors to return to long-term Treasuries for safety. "Current yield levels are quite attractive, and volatility will create more opportunities for us," he said.