The US Treasury market is experiencing a debate over direction: is the Middle East conflict an inflationary threat or a drag on growth? As market sentiment subtly shifts, this question is leaving bond traders torn.
US Treasuries extended their rebound on Tuesday, with the two-year yield edging lower and the ten-year yield retreating significantly from last week's eight-month high. A nuanced change in market mood is emerging—investors are beginning to interpret the Middle East conflict more as a downside risk to global growth rather than purely an inflationary pressure, with safe-haven demand once again supporting US bonds. Meanwhile, sharp swings in oil prices during the day further heightened market uncertainty.
However, this shift does not imply that the direction is clear. The core dilemma facing traders is that the war simultaneously pushes up inflation expectations and recession risks. These two opposing forces are pulling the market in different directions, making it difficult to form a consensus and further clouding the Federal Reserve's policy path.
Market sentiment is shifting, with safe-haven logic regaining dominance. US Treasuries rose for a second consecutive day on Tuesday. The two-year yield fell by 1 basis point to 3.82%, after having declined by 8 basis points the previous day. The ten-year yield dropped by 2 basis points to 4.33%, notably lower than last week's peak of 4.48%.
Despite this, the two-year yield has still climbed over 40 basis points since the outbreak of the war and is on track for its largest monthly increase since October 2024, indicating that market pricing for inflationary pressures has not fully subsided.
Andrew Ticehurst, Senior Strategist at Nomura Australia, noted, "Over the past few days, we've seen a change in market thinking. Initially, the focus was on the inflationary impact of the Middle East conflict, but I believe the market is now starting to consider more the downside risks to growth." Sharon Bell, Senior European Equity Strategist at Goldman Sachs, also pointed out in an interview with Bloomberg Television that even if the conflict ends quickly, the economic negative effects of a war with Iran would persist.
Oil prices experienced significant volatility on Tuesday, becoming a major source of market disruption. Prices surged intraday following reports that an Iranian drone struck a Kuwaiti oil tanker near Dubai, but then pared gains after The Wall Street Journal reported that former President Trump had indicated to advisors a willingness to end military action against Iran even if the Strait of Hormuz remains largely closed.
This news reflects high uncertainty regarding global energy supply prospects. The Strait of Hormuz is a critical global oil transit route, and its operational status directly influences global energy prices, thereby tilting the balance between inflation and growth expectations.
The deeper conflict facing the market lies in the war triggering both inflationary and recessionary risks simultaneously, severely limiting policy response options. Win Thin, Chief Economist at Brown Brothers Harriman, stated bluntly, "The market is swinging between inflation panic—yields rising—and growth slowdown panic—yields falling. This is the essence of the stagflation dilemma: there is no simple policy solution, making it hard for the market to decide whether to focus on 'stagnation' or 'inflation'."
Currently, traders are betting that the Federal Reserve will keep interest rates unchanged within the 3.5% to 3.75% range this year, with only a small probability priced in for a 25-basis-point rate cut by mid-2027.
Federal Reserve Chair Jerome Powell stated on Monday that long-term inflation expectations appear anchored for now, but 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, and markets will be looking for further clues on the interest rate path.
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