Market Strategists Forecast Continued High Yields Despite Potential Iran Conflict Resolution

Market Borrowing Costs May Remain Elevated Despite Potential End to Iran War

Inflation concerns stemming from the Iran war have been a major focus of attention in the financial markets. However, signs suggest that other factors are having a more significant impact on longer-term borrowing costs. In the United States, real yields, which strip out inflation, have had a greater influence, indicating that bond investors are not solely concerned with price pressures from the war.

According to a Bloomberg analysis, the recent jump in some long-term yields is unlikely to fully reverse even if the inflation spurred by costlier oil retreats. This could keep market borrowing costs elevated around multiyear highs even after the conflict ends, placing pressure on governments and economies.

The argument that rising inflation fears are driving the sell-off in long-term bonds globally is not supported by market pricing of medium- and long-term inflation risk. Instead, the interaction between rising debt levels, potentially higher neutral rates, and the impact of the AI investment boom could be driving real rates higher.

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The neutral rate is the level at which neither the economy is spurred nor slowed. Even with the war underway, 10-year breakeven rates in the US are 50 basis points below where they were in the first half of 2022, when the Federal Reserve was raising interest rates. The 5-year, 5-year breakeven rate, a proxy for market-based measures of medium-term inflation expectations, is around 2.2%, similar to levels seen in December.

Note: The above table shows the 10-year breakeven rate and 5-year, 5-year breakeven rate for the US, UK, Japan, and Germany.

The interaction between rising debt levels and potentially higher neutral rates could justify higher yields, as 5% rates on 10-year Treasuries are no longer seen as a bargain. The neutral rate might have risen, which would also justify higher yields.

Read also: US-Iran Tensions Spark Uptick in Oil Prices Amid Global Market Decline

The bond market is not reacting to one headline, but rather repricing a structural problem that cannot be solved with a press release or diplomatic pause. The reasons to expect yields to stay lofty in the US include the ongoing trade war, which is stymieing supply chains, and the push to cut taxes, adding to an already large debt burden and subsequent need to sell Treasuries.

In an interview with Bloomberg Television, Jamie Dimon, chief executive officer of JPMorgan Chase & Co., said US interest rates may climb much further, citing concern about government borrowing and demand for the debt. Phillip Lee, head of real money rate sales at Goldman Sachs, also believes that persistent fiscal deficits, more Treasury issuance, and concerns over debt sustainability are driving investors to demand extra compensation to own long-term debt.

Note: The above table shows the reasons for elevated yields in the US, UK, Japan, and Germany.

The analysis suggests that the recent jump in long-term yields is unlikely to fully reverse, even if the inflation spurred by costlier oil retreats. This could keep market borrowing costs elevated around multiyear highs even after the conflict ends, placing pressure on governments and economies.