Inflation concerns tied to higher energy costs have pushed U.S. Treasury yields higher since the recent clash with Iran. A new source of pressure on the bond market is emerging - the fiscal toll of an extended conflict.
Market participants and economists still largely expect the confrontation to end soon, a development that would ease both oil prices and strain on U.S. finances. Nonetheless, a number of analysts are calculating what a longer-running conflict would mean for the budget: additional defense spending, refunds related to tariff decisions and the potential for stimulus if growth deteriorates sharply.
Those added fiscal burdens could become a significant concern for investors already showing less appetite for bonds. The S&P U.S. Aggregate Bond Index has returned -0.6% so far in the first quarter, reflecting that softer reception.
Bigger deficits on the table
Even before new war-related demands, the U.S. fiscal position was already stretched. The national debt is at a record $39 trillion, and annual net interest payments are projected to reach $1 trillion this fiscal year. At the same time, the Pentagon has requested more than $200 billion in supplemental funding related to the Iran conflict, on top of the roughly $900 billion defense bill already signed for fiscal year 2026.
BNP Paribas projects the U.S. deficit to remain just below 6% of GDP across 2026 and 2027. But adding the extra costs tied to an extended conflict could push that gap considerably wider. "You get from a deficit that's just below 6% to something that could easily be closer to 8% or even a bit above," said Andrew Husby, senior economist at BNP Paribas. That level of deterioration in the public finances is hardly what bond investors prefer to see.
Compounding revenue pressures, the Supreme Court ruled that the president cannot use emergency powers to impose tariffs, a decision that could require about $175 billion in refunds to importers. The administration has indicated it will seek replacement tariffs under separate legal authority, but it is not clear whether those would fully offset the lost revenue.
Signs of stress in the bond market
The most aggressive selling has been concentrated in short-term yields, a development that reflects fading hopes for near-term Federal Reserve rate cuts. Longer-dated yields have also moved up, however. The 10-year Treasury briefly approached 4.5% for the first time since last summer, and some Treasury auctions this month have drawn weak demand.
"All of these little costs seem to be adding up," said Bill Campbell, a portfolio manager at DoubleLine Capital. Market participants are watching whether incremental fiscal strains, when combined, become large enough to alter the trajectory of yields across the curve.
Markets not yet pricing a large fiscal shift
So far, markets do not appear to be repricing U.S. fiscal risk aggressively. "There's not a ton of extra fiscal risk really being priced right now," said BNP's Husby, noting that investors may wait for concrete legislation before responding more forcefully.
Dirk Willer, head of macro and asset allocation strategy at Citigroup, highlighted a particular danger: that the Federal Reserve could be unable to ease policy by cutting rates if inflation remains elevated while fiscal spending is increasing and the Fed is also reducing the size of its balance sheet. In that scenario, fiscal policy could reassert itself as a dominant driver of market outcomes.
Near-term threats and contingent responses
Analysts point to nearer-term risks that could prompt sharper market moves. Robert Tipp, chief investment strategist and head of global bonds at PGIM Fixed Income, warned that a combination of sustained growth and persistent inflation could force the U.S. to maintain a hiking bias or to raise rates this year - an outcome that would exert further upward pressure on yields.
Christian Hoffmann, head of fixed income at Thornburg Investment Management, observed that repeated geopolitical shocks in recent years that proved manageable have conditioned investors to underreact. That tendency may persist until a clearly disruptive event breaks the pattern. "We might be at the cusp of that right now," he said.
If longer-term yields continue to rise, the Treasury could respond by shifting issuance strategy. Campbell at DoubleLine said that a 30-year yield rising to 5.25% from a recent 4.95% would be "a big problem" and could prompt the government to reduce long-dated issuance in favor of short-term bills.
There are divergent views on how the sequence might play out. Mike Cudzil, a portfolio manager at PIMCO, expects that an oil-driven shock would eventually slow growth, which would forestall further rate hikes and potentially allow the Fed to cut later in the year - a dynamic that could push yields lower. On that basis PIMCO has been adding longer-dated debt across developed markets.
Where the pressure lands
What ultimately matters for markets is the combination of trajectory and policy action. Small, incremental fiscal and geopolitical costs have been enough to move short-term yields so far; sustained or larger additions to deficit financing could raise borrowing costs more broadly, test demand at Treasury auctions and alter the composition of issuance.
Investors and policymakers both face uncertainty. Markets may remain calm until the legislative picture becomes clearer, or they may begin to price in higher fiscal risk sooner if the conflict and related costs persist.
For now, the question hangs between two outcomes: one in which an end to the confrontation brings relief to oil prices, inflation expectations and the fiscal ledger, and another in which extended defense spending, tariff refunds and potential stimulus widen deficits and add to the upward pressure on yields.