Iran Tensions Trigger Recovery in U.S. Lending Rates

Market Turmoil Follows U.S.-Israeli Strikes on Iran

Wreckage left behind after a building in Tehran was hit. - Majid Asgaripour/Wana News Agency/Reuters

Recent military actions by the United States and Israel targeting Iran have abruptly ended a sustained rally in U.S. government bonds. As a result, yields on the 10-year Treasury note have surged above 4%, raising the prospect of increased borrowing expenses for both consumers and businesses.

The escalation has triggered heightened volatility in stock markets, a situation that would typically drive investors toward the relative safety of bonds. However, the concurrent spike in energy prices has taken precedence, fueling concerns about renewed inflation that could further depress bond prices.

Top Stories from The Wall Street Journal

• After Powell, Can the Fed Stay Independent?
• Starbucks to Open Nashville Office, Relocate Supply-Chain Workers
• In a Day of Wild Market Moves, Oil Is a New Haven
• OpenAI CEO Sam Altman Defends Pentagon Work to Staff, Calls Backlash ‘Really Painful’
• Vail Cuts Ski Pass Price for Gen Z Skiers

On Monday, Treasury yields—which move inversely to bond prices—recorded their sharpest single-day increase since June of last year. The upward trend has persisted, with the 10-year yield reaching as high as 4.1%.

This reversal has disappointed many investors, especially since yields seemed ready to break below their recent trading range. The 10-year Treasury yield is a key benchmark for borrowing costs throughout the economy, and its drop in February helped bring 30-year mortgage rates below 6% for the first time in over three years.

Recently, Treasurys had started to serve as a buffer against stock market swings, regaining some of their traditional appeal as inflation fears had eased. Now, however, “the market is seeing more persistent inflation effects and less of the usual flight to safety,” explained Zach Griffiths, head of investment-grade and macro strategy at CreditSights.

For investors, the main risk from inflation is that it could force the Federal Reserve to keep short-term interest rates higher, or delay expected rate cuts. Higher rates tend to make bonds less attractive compared to alternatives like money-market funds.

Rising oil and gas prices can push overall inflation higher. While the Fed typically focuses on core inflation, which excludes volatile food and energy prices, significant energy price shocks can have broader effects, influencing the cost of other goods and shaping long-term inflation expectations—something economists warn can become self-reinforcing.

The ongoing conflict in the Middle East is already driving up market-based measures of expected inflation.

Shifting Inflation and Rate Expectations

The difference between yields on five-year nominal Treasurys and their inflation-protected counterparts—a measure known as the breakeven rate—has risen above 2.5%, up from 2.46% at the end of last week.

Meanwhile, investors are scaling back their expectations for interest-rate reductions this year. The probability of two rate cuts, as indicated by federal-funds futures, has dropped to about 55% from 79% last Friday.

Even before the latest geopolitical risks, the Fed was contending with stronger price pressures, as indicated by its preferred inflation gauge, the personal-consumption expenditures price index. Based on January’s consumer and wholesale data, a key measure excluding food and energy is set to show its largest monthly increase in a year when reported next week.

The situation with Iran remains unpredictable, and market reactions could shift rapidly. Brent crude futures, the global oil standard, briefly surpassed $85 per barrel early Tuesday—the highest since mid-2024—before retreating to around $80 after reports that the U.S. and other nations would work to secure global shipping lanes.

Historically, when Treasurys have faced conflicting pressures, they have sometimes moved sharply in one direction only to reverse course. For example, following President Trump’s tariff announcement last April, Treasurys initially rallied but then sold off sharply.

Before the recent missile strikes, Treasury yields had been declining, with the 10-year yield closing last Friday at a four-month low of 3.961%.

This downward movement was driven less by economic data and more by a flight to safety amid concerns about artificial intelligence’s potential to disrupt certain sectors. Treasurys also benefited from a rebound in Japanese government bonds, which had faced intense pressure in January, affecting global markets.

Investor Outlook Remains Divided

Despite the recent volatility, some investors remain optimistic about Treasurys. John Madziyire, who leads U.S. Treasurys at Vanguard, believes that longer-term yields could move lower as the effects of tariffs diminish, allowing inflation to subside and the Fed to resume rate cuts in the latter half of the year.

He notes that while higher energy prices from a prolonged conflict with Iran could delay rate cuts, they might also slow economic growth and drive investors back toward the safety of long-term government bonds.

“Current yield levels are appealing, and the ongoing volatility will likely create more opportunities for us,” Madziyire said.

More Popular Reads from The Wall Street Journal

• Blackstone Played Down Private-Credit Risks. Now It’s Been Hit.
• The AI Evangelist Shaking Up a 220-Year-Old Toothpaste Maker
• Meta to Create New Applied AI Engineering Organization
• Senate Democrats to Propose Meat Industry Breakup
• Verizon Recently Weighed Pulling Back On NFL Sponsorship Deal