The U.S. Treasury market is experiencing a battle for direction: is the Middle East war an inflationary threat or a drag on growth? As the market narrative subtly shifts, this question is putting bond traders in a difficult position.
Treasuries extended their rebound on Tuesday, with the two-year yield falling slightly and the 10-year yield retreating significantly from its eight-month high of last week. Market sentiment has undergone a subtle shift—investors are beginning to interpret the Middle East conflict more as a downside risk to global growth rather than purely an inflationary pressure, with safe-haven demand providing support for U.S. Treasuries again. At the same time, oil prices fluctuated sharply during the day, further exacerbating market uncertainty.
However, this shift does not mean the direction has become clear. The core dilemma facing traders is: the war simultaneously boosts inflation expectations and recession risks, creating a tug-of-war that makes it difficult for the market to form a consistent judgment and further obscures the Federal Reserve's policy path.
<h2>Market Narrative Shifts, Safe-Haven Logic Reasserts Dominance</h2>
U.S. Treasuries rose for the second consecutive day on Tuesday. The two-year yield fell 1 basis point to 3.82%, after having fallen a cumulative 8 basis points the previous day; the 10-year yield fell 2 basis points to 4.33%, a notable retreat from the eight-month high of 4.48% touched last week.
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Despite this, the two-year yield has still risen by more than 40 basis points since the outbreak of the war and is on track for its largest monthly gain since October 2024, indicating that the market's pricing of inflationary pressures has not completely subsided.
Andrew Ticehurst, a senior strategist at Nomura in Australia, said, &#34;In the past few days, we've seen a shift in market thinking. Initially, the market focused on the inflationary impact of the Middle East conflict, but I think the market is now starting to consider the downside risks to growth more.&#34;
Sharon Bell, a senior European equity strategist at Goldman Sachs, also noted in an interview with Bloomberg Television that even if the conflict ends quickly, the negative economic impact of the war in Iran will persist.
<h2>Oil Price Volatility Exacerbates Market Divergence</h2>
Oil prices experienced significant fluctuations on Tuesday, becoming a major disruptive factor in market sentiment for the day. Prices briefly surged on news of an Iranian drone hitting a tanker near Dubai, but later, according to The Wall Street Journal, Trump told aides that he was willing to end military action against Iran even if the Strait of Hormuz remained largely closed, causing oil prices to narrow their gains.
This news reflects the high degree of uncertainty in the market regarding the outlook for energy supply. The Strait of Hormuz is a critical global oil shipping channel, and its transit status directly affects global energy price trends, thereby influencing the balance between inflation and growth expectations.
<h2>Stagflation Dilemma, Policy Path Unclear</h2>
The deep-seated contradiction facing the market is that the war has simultaneously triggered both inflationary and recessionary risks, leaving policy response options extremely limited.
Win Thin, chief economist at Nassau1982 Bank, bluntly stated, &#34;The market is oscillating between inflation fears—rising yields—and slowing growth fears—falling yields. This is the crux of the stagflation problem: there are no simple policy responses, making it difficult for the market to determine whether to focus on 'stag' or 'flation'.&#34;
Currently, traders are betting that the Federal Reserve will keep interest rates unchanged in the 3.5% to 3.75% range this year, with only a small probability of a 25-basis point rate cut by mid-2027.
Federal Reserve Chairman Powell stated on Monday that long-term inflation expectations appear to remain under control, but the Fed is closely monitoring the impact of the war. Fed Vice Chair for Supervision Michelle Bowman and Governor Michael Barr are scheduled to speak on Tuesday evening, and the market will be looking for further clues on the interest rate path.

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U.S. Treasuries extended their rebound on Tuesday, as investors began to interpret the Middle East conflict more as a downside risk to global growth rather than purely an inflationary pressure, with safe-haven demand providing support for Treasuries again. However, the war simultaneously boosts inflation expectations and recession risks, creating a tug-of-war that makes it difficult for the market to form a consistent judgment and further obscures the Federal Reserve's policy path

- The U.S. Treasury market is facing a struggle between inflation threats and growth concerns due to ongoing Middle East conflicts, causing confusion among bond traders.  
- Recently, yields on two-year and ten-year Treasuries declined as investors shifted their focus towards the risks of global economic downturn, amidst significant volatility in oil prices.  
- This complex situation poses challenges for the Federal Reserve, with inflation and recession fears pulling in opposite directions, leaving market participants uncertain about future policy directions.

Inflation or Recession? U.S. Treasury Market in a Dilemma!