The inflationary shock triggered by the Iran conflict has already pushed up U.S. Treasury yields. As the possibility of prolonged conflict rises, the bond market faces another threat: the continuously escalating fiscal costs of war.
Analysts warn that if defense spending for prolonged wars, tariff refunds, and potential economic stimulus measures are combined, the U.S. fiscal deficit could jump from its current level of nearly 6% of GDP to 8% or even higher. This prospect poses a new hidden danger to the already strained bond market—the S&amp;P U.S. Aggregate Bond Index has already fallen 0.6% in the first quarter.
Currently, Wall Street's mainstream expectation leans towards a short-term end to the conflict, anticipating that oil prices and fiscal pressures will subsequently ease. However, some analysts point out that the market has not fully priced in the potential fiscal risks, and once actual legislation advances, the bond market's reaction could be more intense.
<h2>Fiscal Gap May Widen Significantly, Yield Curve Already Shows Signs of Pressure</h2>
The U.S. fiscal situation was already precarious before the initial strikes against Iran on February 28th of this year. National debt has reached a record $39 trillion, with net interest payments for the current fiscal year projected to exceed $1 trillion.
War expenditures have further exacerbated this pressure. The Pentagon is requesting over $200 billion in supplemental appropriations from Congress for the Iran conflict, on top of the approximately $900 billion defense budget for fiscal year 2026 that has already been signed into law. Simultaneously, a Supreme Court ruling that the president cannot levy tariffs under emergency powers might compel the government to refund approximately $175 billion to importers. Although authorities state they will impose alternative tariffs under different legal authorizations, uncertainty remains regarding whether this can fully bridge the revenue gap.
Andrew Husby, a senior economist at BNP Paribas, stated that considering these factors, the U.S. deficit &#34;could easily rise from nearly 6% to close to 8% or even higher,&#34; a trend that bond investors would not welcome.
The current selling pressure in the bond market is mainly concentrated in the short end, reflecting the market's cooling expectations for imminent rate cuts by the Federal Reserve. However, longer-term yields have also risen; the 10-year Treasury yield approached 4.5% this month for the first time since last summer, and some Treasury auctions have shown weak demand.
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Bill Campbell, a portfolio manager at DoubleLine Capital, commented, &#34;All these small costs seem to be accumulating.&#34; He warned that if the 30-year Treasury yield rises from its recent 4.95% to 5.25%, &#34;that would be a big problem,&#34; potentially prompting the Treasury Department to reduce long-term bond issuance and increase the supply of short-term Treasury bills instead.
<h2>Market Has Not Fully Priced Fiscal Risks</h2>
Despite the emerging warning signs, the market has not yet significantly repriced the U.S. fiscal outlook. Andrew Husby noted that the market might be waiting for actual legislation to take shape before reacting more strongly, stating, &#34;There isn't a lot of extra fiscal risk being truly priced in right now.&#34;
Dirk Willer, Head of Macro and Asset Allocation Strategy at Citigroup, believes the biggest risk lies in a scenario where: if inflation persists, the Fed is unable to cut rates, and fiscal spending expands concurrently, coupled with potential balance sheet reduction by the Fed, then &#34;fiscal factors could re-emerge to a greater extent,&#34; posing a more significant shock to the bond market.
Analysts point out that compared to long-term fiscal concerns, more immediate threats stem from the Federal Reserve's potential pivot towards rate hikes and the ongoing escalation of geopolitical risks.
Robert Tipp, Chief Investment Strategist and Global Bond Head at PGIM Fixed Income, warned that a &#34;when the other shoe drops&#34; scenario would be if economic growth continues, inflation remains high, and the Fed shows a tendency towards, or actually implements, a rate hike this year.
Christian Hoffmann, Head of Fixed Income at Thornburg Investment Management, observed that geopolitical shocks over the years have ultimately proven manageable, conditioning investors into a habit of underestimating risks. &#34;We might be at a tipping point where that pattern is broken.&#34;
Meanwhile, Mike Cudzil, a portfolio manager at PIMCO, holds a relatively optimistic view, believing that the oil price shock will eventually drag down economic growth, thereby preventing rate hikes and creating room for the Fed to cut rates later this year, leading to a pullback in yields. PIMCO has already increased its holdings of long-term bonds in several developed markets based on this assessment.

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Analysts warn that defense spending for prolonged wars, tariff refunds, and potential economic stimulus measures could cause the U.S. fiscal deficit to jump from nearly 6% of GDP to 8% or higher. However, the market has not fully priced in the potential fiscal risks, and once actual legislation advances, the bond market's reaction could be more intense

- The inflation impact from the Iran war has elevated U.S. Treasury yields amid rising conflict and escalating war finance costs.  
- Analysts warn that defense spending increases could push the U.S. fiscal deficit from nearly 6% of GDP to 8% or more, putting further pressure on the already strained bond market.  
- Despite these risks, the market has yet to adjust significantly, with some experts concerned about possible interest rate hikes and ongoing geopolitical tensions affecting the fiscal outlook.

US Debt Market's Next Test: Rising War Costs