US Stock Market | Rising war costs and inflation risks cloud outlook for US bond market

Mounting inflation risks and the potential fiscal burden of a prolonged conflict are emerging as key concerns for U.S. bond markets, even as investors continue to hope for a short-lived geopolitical crisis, according to a report by Reuters.

Treasury yields have climbed in recent weeks as energy prices surged following the U.S. military clash with Iran, a development that has heightened inflation fears. According to the report, the spike in oil prices has added pressure on fixed-income markets, with investors reassessing expectations for Federal Reserve rate cuts.

While Wall Street largely anticipates that the conflict will de-escalate soon, some analysts are increasingly focused on the financial implications of a longer war. These include higher defense spending, potential tariff refunds, and the possibility of fiscal stimulus if economic growth weakens sharply. Such factors could further strain a bond market already showing signs of fatigue, with the S&P U.S. Aggregate Bond Index delivering a negative return of 0.6% in the first quarter, Reuters data showed.


Economists warn that the U.S. fiscal outlook could deteriorate significantly under a prolonged conflict scenario. Reuters cited estimates from BNP Paribas suggesting that while the fiscal deficit is projected to remain just under 6% of GDP in 2026 and 2027, additional war-related costs could push it closer to 8% or higher, an outcome that would likely unsettle bond investors.

Signs of mounting stress

The bond sell-off has been most pronounced at the short end of the yield curve, reflecting diminishing expectations of near-term rate cuts. However, longer-dated yields have also moved higher. As per the report, the benchmark 10-year Treasury yield briefly approached 4.5%, a level not seen since last summer, while some recent Treasury auctions have seen tepid demand.

Market participants say the accumulation of fiscal pressures is becoming harder to ignore. Portfolio managers point to a growing list of cost drivers that could weigh on government finances and, by extension, bond valuations.

The U.S. fiscal position was already under strain before the escalation with Iran. National debt has reached a record $39 trillion, with annual net interest payments expected to touch $1 trillion this fiscal year. Additional spending pressures are building, including over $200 billion in supplemental defense funding tied to the conflict, on top of an already approved $900 billion defense budget for fiscal 2026.

Compounding the issue, a recent Supreme Court ruling restricting the use of emergency powers for tariffs could force the government to refund roughly $175 billion to importers, further denting revenues. Although the administration plans to introduce alternative tariffs, uncertainty remains over whether these will fully offset the loss.

Markets yet to fully react

Despite these concerns, financial markets have so far shown limited signs of pricing in a significantly worse fiscal trajectory. Investors may be waiting for concrete legislative developments before adjusting their outlook more aggressively.

However, strategists caution that risks could build if inflation remains elevated while fiscal spending rises. Such a scenario could limit the Federal Reserve’s ability to cut rates, or even force it to maintain a tighter stance, complicating the outlook for bonds.

Key risks ahead

In the near term, the trajectory of inflation and monetary policy will remain critical. The report by Reuters cited market experts who warn that if economic growth holds up while inflation stays high, the Federal Reserve could be pushed toward a rate hike bias, an outcome that would likely drive yields even higher.

At the same time, some investors believe that the oil shock could eventually slow economic activity, easing inflation pressures and allowing rate cuts later in the year. Certain asset managers are positioning for this possibility by increasing exposure to longer-dated bonds.

Another risk lies in shifting investor behavior. Repeated geopolitical shocks in recent years have conditioned markets to underreact, but this pattern may not hold indefinitely if fiscal and inflation pressures intensify.

Should long-term yields continue to rise sharply, the U.S. Treasury may be forced to adjust its borrowing strategy. This could involve reducing issuance of long-dated debt in favor of shorter-term bills to manage borrowing costs more effectively.

The interplay between geopolitical risks, inflation dynamics, and fiscal pressures is creating a complex backdrop for U.S. bond markets. While investors remain cautiously optimistic about a resolution to the conflict, the longer it drags on, the greater the risk that rising costs and persistent inflation could reshape market expectations, potentially leading to a more challenging environment for fixed-income assets.