Inflation or recession? The U.S. bond market is caught in a dilemma!

Ask AI · How does the Middle East war affect inflation and recession expectations in the U.S. bond market?

The U.S. bond market is experiencing a tug-of-war: Is the Middle East war a threat to inflation or a drag on growth? As market narratives subtly shift, this question is causing bond traders to be caught in a dilemma.

On Tuesday, U.S. markets continued their rebound, with the two-year yield slightly declining and the 10-year yield significantly retreating from last week’s eight-month high. Market sentiment has experienced a subtle change — investors are beginning to interpret the Middle East conflict more as a downside risk to global growth rather than purely inflationary pressure, and the demand for safe assets is once again supporting U.S. bonds. Meanwhile, oil prices fluctuated sharply during the day, further increasing market uncertainty.

However, this shift does not mean the direction has become clear. The core dilemma faced by traders is: The war simultaneously raises inflation expectations and recession risks, with these forces pulling in opposite directions, making it difficult for the market to form a consensus view, and also making the Federal Reserve’s policy path increasingly ambiguous.

Market narrative shifts, safe-haven logic regains dominance

U.S. Treasuries rose for the second consecutive day on Tuesday. The two-year yield fell by 1 basis point to 3.82%, after declining by 8 basis points the previous day; the 10-year yield fell by 2 basis points to 4.33%, retreating significantly from last week’s eight-month high of 4.48%.

Nevertheless, since the outbreak of the war, the two-year yield has still risen by over 40 basis points, and is on track to post the largest monthly gain since October 2024, indicating that the market’s inflation expectations have not fully subsided.

Andrew Ticehurst, senior strategist at Nomura Australia, said: “In the past few days, we’ve seen a shift in market thinking. Initially, the market focused on the inflation impact of the Middle East conflict, but I believe now the market is starting to consider more the downside risks to growth.”

Sharon Bell, senior European equity strategist at Goldman Sachs, also pointed out in an interview with Bloomberg TV that even if the conflict ends quickly, the negative economic impact of the Iran war will persist.

Oil prices fluctuate sharply, intensifying market divergence

Oil prices experienced significant volatility on Tuesday, becoming an important factor disrupting market sentiment. During the day, oil prices surged due to news that an Iranian drone hit a Kuwaiti oil tanker near Dubai, but later, according to The Wall Street Journal, Trump told aides that even if the Strait of Hormuz remains largely closed, he would be willing to end military actions against Iran, causing oil prices to narrow their gains.

This news reflects the high uncertainty in the energy supply outlook. The Strait of Hormuz is a critical global oil transit route; its status directly influences global energy prices, which in turn sway the balance between inflation and growth expectations.

Stagflation dilemma, policy path remains unclear

The deep contradiction currently facing the market is that the war triggers both inflation and recession risks simultaneously, leaving very limited room for policy responses.

Nassau 1982 Bank Chief Economist Win Thin said: “The market is swinging back and forth between inflation panic — yields rising — and growth slowdown panic — yields falling. This is the core of the stagflation problem: there is no simple policy response, and the market finds it hard to decide whether to focus on ‘stagnation’ or ‘inflation’.”

Currently, traders are betting that the Federal Reserve will keep interest rates between 3.5% and 3.75% this year, with only a small probability of a 25 basis point cut before mid-2027.

Fed Chair Powell said on Monday that long-term inflation expectations still appear to be under control, but the Fed is closely monitoring the war’s impact. Vice Chair Michelle Bowman and Board Member Michael Barr will speak on Tuesday evening, and markets will look for more clues on the interest rate path from their remarks.