The inflationary shock stemming from the U.S.-Iran conflict is reshaping market expectations for the Federal Reserve's policy path. During Tuesday's trading session, the spread between 5-year and 30-year U.S. Treasury yields narrowed to approximately 81 basis points at one point, hitting its lowest level since May 2025. Simultaneously, pricing from traders now indicates the Fed is almost certain to initiate interest rate hikes before December, marking a stark reversal from market expectations for two rate cuts prior to the outbreak of the U.S.-Iran conflict.
Investors are increasingly convinced that the U.S.-Iran war has triggered the largest inflationary shock since 2023, forcing numerous officials to abandon their previous dovish stances and compelling the Fed to tighten monetary policy this year. Although expectations for U.S.-Iran peace talks warmed on Monday, leading to a pullback in oil prices, Steven Major, a global macro strategist at a Dubai brokerage, noted:
The bond market has too many things to worry about; conflict in this region is just one part of the story. The bond market is far from stable and is becoming somewhat unpredictable, which also explains why yields are staying elevated.
Chen from Brandywine also emphasized that the structural factors pressuring the bond market will not dissipate with a temporary easing of geopolitical tensions, and investors need to remain vigilant for a sustained high-interest-rate environment.
Behind the Curve Flattening: Short-End Pressure, Long-End Relative Stability
The core logic behind the flattening yield curve lies in the divergent movements of the short and long ends. The 5-year U.S. Treasury yield climbed to a yearly high of 4.35% last week, closing Friday at 4.26%; the benchmark 10-year yield stood at 4.56%; meanwhile, the 30-year yield retreated from its yearly peak of around 5.20% to 5.06%, partly due to the recent decline in oil prices. (Movement of key U.S. Treasury yields last week) The spread between 2-year and 30-year yields also narrowed to its lowest level since July. Andrew Ticehurst, a senior strategist at Nomura, stated:
Both data and political factors are alleviating pressure for rate cuts, leading to continued upward repricing at the short end.
He added that former President Trump's comments about letting Warsh "operate independently" have also contributed to this dynamic. Markets live strategist Garfield Reynolds pointed out that accelerating global inflation implies the Fed and other major central banks will maintain a hawkish stance, suppressing the short end, while the long end finds relative support as signs emerge that the global growth outlook is being severely impacted.
Officials and Wall Street: Rate Hikes Are No Longer a Low-Probability Event
Shifts in rhetoric from policymakers are reinforcing market pricing for rate hikes. On Friday, May 22, Fed Governor Waller delivered hawkish remarks, explicitly stating that inflation is the "driving force" for future policy decisions and characterizing the odds of future rate hikes versus cuts as a "coin toss." This statement directly fueled a sharp升温 in rate hike expectations. Mainstream Wall Street institutions are concurrently adjusting their forecasts. JPMorgan Chase CEO Jamie Dimon warned that interest rates could rise significantly further. According to reports, strategists at ING, Goldman Sachs, and Barclays all believe that even if oil-driven inflationary pressures ease somewhat, the gains in long-end yields will be difficult to fully reverse, as the structural impacts of massive public debt burdens and the AI investment boom will continue to unfold. Brandywine portfolio manager Tracy Chen stated in an interview that so-called "bond vigilantes" are warning that central banks have fallen behind the curve. She estimates:
Even with some easing in oil prices, I don't believe the structural sell-off in developed market bonds is over.
She believes the 10-year yield could ultimately rise to 5%, with some maturities potentially touching 5.5% to 6% for a period, driven by factors including loose fiscal policy, massive spending on defense and AI infrastructure, an aging population, and geopolitical turmoil.
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