Despite widespread concerns over war-related inflation, strategists indicate that other factors are equally influential in driving long-term borrowing costs higher. In the United States, real yields—which exclude inflation—have had a more pronounced impact, suggesting that bond investors are not solely focused on price pressures stemming from the Iran conflict.
Key Drivers Beyond the War
Other culprits include already substantial public debt burdens that are expected to swell further, fallout from the artificial intelligence investment boom, and the rising possibility that central banks, such as the U.S. Federal Reserve, may raise interest rates rather than cut them. This speculation, underscored by a Bloomberg analysis and highlighted by strategists at ING Bank NV, Goldman Sachs Group Inc., and Barclays Plc, suggests that the recent jump in some long-term yields will not fully reverse even if inflation spurred by costlier oil retreats.
Risks of Sustained High Borrowing Costs
This scenario risks keeping market borrowing costs elevated around multiyear highs even after the conflict ends, maintaining pressure on governments and economies. "The argument that duration is selling off globally due to inflation fears is hard to square with market pricing of medium- and long-term inflation risk," said Jonathan Hill, head of U.S. inflation strategy at Barclays. "Instead, the interaction between rising debt levels, potentially higher neutral rates, and AI could be driving real rates higher." The neutral rate is the level that neither spurs nor slows the economy.
While the surge in oil prices may be capturing headlines, breakeven rates that measure bond market inflation expectations have not risen as far as overall rates in the U.S. and U.K. Hill notes that even with the war underway, 10-year breakevens in the U.S. are 50 basis points below where they were in the first half of 2022, when the Fed was aggressively raising rates. The five-year, five-year breakeven rate—a proxy for medium-term inflation expectations—remains around 2.2%, similar to levels seen in December.
Yield Curve Analysis
At Bank of America Corp., economists Claudio Irigoyen and Antonio Gabriel are monitoring shifts in the yield curve, specifically the gap between long- and short-term yields, to determine what is moving bond markets. "In an environment where the Fed could potentially be on the table and become a driver of even larger fiscal deficits amid rising debt servicing costs, the long end of the curve becomes more sensitive to what should be primarily a move in short-end rates," they said.
Subtracting inflation-adjusted yields from nominal rates leaves real yields, which some market participants view as a truer measure of borrowing costs. A Bloomberg analysis shows that rising real yields explain most of the move higher in overall yields in the U.S., while inflation is the major influence in Japan and Germany. Such trading means that even if the Strait of Hormuz—a critical chokepoint for global energy flows that has been closed by the war—is eventually reopened, long-term rates "could find themselves a tad stranded at elevated levels" as real yields stay high, said Padhraic Garvey, regional head of research for the Americas at ING.
