Leading bond fund managers on Wall Street are warning that financial markets are severely underestimating the risk of a sharp economic slowdown in the United States, triggered by military action against Iran, which would impact an already fragile economy. With international oil prices surpassing $110 per barrel and no signs of the conflict abating, market focus remains squarely on the inflation shock. This has driven the U.S. Treasury market to its worst monthly sell-off since October 2024, as investors bet on further Federal Reserve interest rate hikes within the year.
However, major asset managers, including Pacific Investment Management Co. (PIMCO), J.P. Morgan, and Columbia Threadneedle Investments, are beginning to position for an economic recession. They anticipate that economic weakness will ultimately trigger a bond market rally, leading to a significant decline in yields. Kelsey Berro, a fixed income portfolio manager at J.P. Morgan Asset Management, stated, "Each day the conflict continues, the market moves closer to being forced to confront the negative effects on economic growth, which will ultimately push down U.S. Treasury yields. Current yield levels have broadly risen to attractive heights."
As soaring energy prices, rising borrowing costs, and a sharp stock market decline begin to pressure businesses and consumers, economists are revising growth forecasts downward and increasing the probability of a recession. Goldman Sachs estimates the probability of a U.S. recession within the next 12 months has risen to approximately 30%, while PIMCO places the probability at over one-third.
Typically, pessimistic economic outlooks benefit bonds, as they increase the likelihood of the Federal Reserve cutting rates to stimulate the economy. However, the current situation is markedly different. Traders believe surging energy prices will constrain the Fed, which is already battling stubbornly high inflation, making rate cuts difficult. The resulting intense bond sell-off has driven yields sharply higher across the board. Since the U.S. airstrikes late last month, yields on two-year and five-year Treasury notes have jumped more than 50 basis points; the 30-year yield is approaching 5%, nearing its peak from 2023 when the Fed pushed interest rates to their highest level in over two decades.
This movement primarily reflects market concerns that rising energy costs will increase prices for a wide range of goods. The Organisation for Economic Co-operation and Development (OECD) warned last week that the U.S. Consumer Price Index (CPI) could surge to 4.2% this year. Consequently, investors are demanding higher returns on bonds to compensate for inflation erosion.
Yet, seasoned bond investors argue that the current sell-off has created an opportunity to lock in high yields, suggesting that inflation fears are overshadowing threats to economic growth. Daniel Ivascyn, Chief Investment Officer at PIMCO, which manages over $2 trillion in assets, said, "Shocks that begin with inflation often rapidly evolve into growth shocks. We are at a tipping point toward significantly weaker economic conditions."
In fact, U.S. economic risks were accumulating even before the outbreak of war. Since the re-imposition of tariffs and the disruption of global trade following the return to the White House, the job market has continued to cool. U.S. employers cut 92,000 jobs in February, and data for March, due Friday, is expected to show only a modest rebound, with job growth potentially around 60,000. Additionally, markets have been unsettled by concerns related to artificial intelligence (AI) and localized stress in the private credit industry.
Now, the ongoing conflict, now in its fourth week, has effectively severed oil shipments through the Strait of Hormuz. This shock has already reached consumers, with U.S. gasoline prices rising to their highest level since the post-pandemic inflation surge.
Rick Rieder, Head of Fixed Income at BlackRock, which manages over $2 trillion in assets, believes the Fed should still cut rates to cushion the economic blow. He indicated he would increase purchases of short-term bonds once the economic outlook becomes clearer. "We will watch the developments over the coming weeks, and then I will step in to buy," he said in an interview.
As of Friday, futures markets indicated that traders have completely priced out any chance of a Fed rate cut in 2026, expecting rates to remain steady, while pricing in about a one-in-three chance of a 25-basis-point rate hike within the year.
With the 30-year yield rising, Ed Al-Hussainy, a portfolio manager at Columbia Threadneedle, has begun increasing holdings of long-term bonds. He anticipates that if the Fed hikes rates further, adding new pressure to the economy, long-term yields will ultimately fall. "The more the Fed tightens policy, the more the long end of the bond yield curve will need to price in a premium for total demand and inflation, subjecting it to greater downward pressure," he stated.
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