"War Costs and High Oil Prices" Iran War Rattles U.S. Financial Markets as Pressure Mounts for Fed Tightening and Higher Treasury Yields

Wall Street Increasingly Prices In Further Fed Tightening
Protracted Iran War Compounds U.S. Fiscal and Inflationary Strains
Prospect of Additional Treasury Issuance and Higher Yields Grows, Shaking Safe-Haven Status

Expectations are mounting that the U.S. Federal Reserve’s tightening cycle could accelerate more rapidly than anticipated. The renewed surge in oil-driven inflation amid the protracted Iran war has strengthened the case for further policy-rate increases. Against this backdrop, Wall Street is projecting that benchmark rates could return to levels last seen in 2022–2023, while some analysts are even warning that U.S. Treasuries may no longer perform their traditional safe-haven role during the next economic downturn. The combined impact of war spending, a massive fiscal deficit and monetary tightening has intensified upward pressure on Treasury yields as the U.S. government’s borrowing requirements expand sharply.

BofA’s Interest-Rate Outlook

According to Bloomberg on the 19th local time, Bank of America (BofA) strategists Mark Cabana and Meghan Swiber said in a report released that day that the Fed could raise its benchmark rate to levels reached during the 2022–2023 tightening cycle. The upper bound of the policy rate peaked at 5.5% during that period. By contrast, current pricing in the interest-rate swap market points to a range of 4.5%–4.75%, while the yield on the two-year U.S. Treasury note stood at approximately 4.7% as of the 18th. BofA said markets were still underestimating the Fed’s terminal rate and advised investors to prepare for the possibility of further increases in the two-year Treasury yield, which is particularly sensitive to additional monetary tightening.

The report projected that “the Fed does not currently view monetary policy as restrictive and is likely to continue raising rates until financial conditions become restrictive,” adding that “short-term rates would surge under such circumstances, while long-term rates would remain comparatively stable, producing a pronounced flattening of the yield curve.” BofA also cited the Taylor rule, which calculates an appropriate policy rate based on how far inflation and economic output have deviated from their respective targets. Applying the rule would place the appropriate federal funds rate at 5.3%, according to the bank. Bloomberg noted, however, that the forecast was issued by BofA’s strategist team, which analyzes bond markets and provides clients with investment guidance, rather than by the bank’s economist team, which primarily covers the Fed.

Further Rate-Hike Forecasts Gain Traction

Other Wall Street institutions are likewise anticipating additional tightening. Goldman Sachs’ economics team said in a report released on the 16th, “We are revising our previous forecast that September’s rate increase would be the last and now expect the Fed to deliver another 25-basis-point hike at its next move.” Citing the unanimous support for a rate increase among Fed officials at the September Federal Open Market Committee (FOMC) meeting and Fed Chair Kevin Warsh’s characterization of the move as “a partial withdrawal of monetary accommodation,” Goldman Sachs concluded that “the Fed committee was considerably more hawkish than anticipated.”

Michael Goosay, chief investment officer for global fixed income at Principal Asset Management, also told Yahoo Finance in an interview on the 20th, “This tightening cycle may not end after one or two rate increases,” adding, “If the Fed is seeking a decisive reduction in demand to bring inflation under control, substantially more forceful measures than expected could follow.” Veteran market strategist Ed Yardeni, president of Yardeni Research, similarly said, “A prolonged period of elevated oil prices risks continuing to drive bond yields higher,” arguing that “the Fed’s rate increase last week was merely the beginning of the hiking cycle.” He warned that “the longer oil prices continue to rise, the greater the risk that inflation will become entrenched alongside a robust economic recovery.”

Warning Signs for U.S. Treasuries

Some observers are even warning that U.S. Treasuries could lose their traditional safe-haven status. According to Bloomberg on the 17th, Jeffrey Gundlach, chief executive officer (CEO) of DoubleLine Capital and widely known on Wall Street as the “Bond King,” told an event in New York that “the next U.S. recession will trigger a severe fiscal crisis that could instead push long-term U.S. Treasury yields higher.” Bloomberg described the argument as the inverse of the decades-old convention that bonds function as safe-haven assets during economic downturns.

Gundlach said, “If a recession arrives, enormous attention will be focused on the United States’ fiscal position,” estimating that “the fiscal deficit could widen to 12% of gross domestic product (GDP), while annual interest costs could reach $3 trillion.” Although Bloomberg acknowledged that the forecast could appear somewhat extreme, it said the view reflected investor concerns that bonds may no longer cushion equity-market losses. Gundlach also predicted that policymakers would introduce emergency measures if the surge in long-term rates intensified. If long-term Treasury yields climbed to approximately 6.5%, the Fed could conduct “Operation Twist,” selling short-term Treasuries and purchasing longer-dated securities to force yields lower, while debt restructuring could become possible in a more extreme scenario.

Deepening U.S. Fiscal Crisis

The Iran war has been identified as the fundamental catalyst behind Wall Street’s heightened state of alert. The United States has already incurred enormous costs as the conflict drags on. According to a report released on the 15th by the Congressional Budget Office (CBO), Congress’s nonpartisan budget-analysis agency, U.S. Department of Defense spending stemming from the military confrontation with Iran was estimated at $38 billion as of August 1. The figure includes the cost of replacing munitions expended in combat and equipment lost, additional flight-hour expenses, other operational costs and fuel. If future combat continues at the relatively low intensity seen in May and June, the CBO projects additional costs of $2 billion per month. If hostilities intensify to July levels, monthly costs are expected to reach $3 billion.

The problem is that the U.S. government is assuming these additional war costs while already carrying an enormous debt burden. U.S. Treasury data show that total public debt reached $40.1 trillion as of the 17th, including $32.4 trillion in federal debt held by the public after excluding intragovernmental holdings. The corresponding interest burden is also substantial. The CBO estimates that the federal government’s net interest outlays will reach $1 trillion in fiscal year 2026, equivalent to 3.3% of GDP. Under these conditions, any additional spending related to the Iran war will inevitably deepen the federal government’s fiscal strain. Unless the additional expenditure is offset through higher taxes or cuts to other budget items, the resulting funding shortfall will ultimately have to be covered through borrowing, including Treasury issuance. The Treasury currently projects net marketable borrowing from private investors of $739 billion from July through September this year and plans to raise an additional $628 billion from October through December. If the supply of Treasuries continues to increase at this pace, investors could demand higher returns, driving market interest rates upward.

Table 1. Fiscal Burdens Facing the United States

War-Driven Inflationary Pressure Intensifies

Inflation is also imposing an enormous burden on the U.S. economy. The United States resumed military strikes against Iran after a hiatus of approximately one month by targeting rocket launchers on Iran’s Larak Island on the 30th of last month, after which international oil prices rose sharply. On the 21st, November Brent crude settled at $100.34 per barrel, while October West Texas Intermediate (WTI) crude closed at $95.78. The increase is highly likely to reignite already elevated U.S. inflation. According to the U.S. Bureau of Labor Statistics (BLS), the Consumer Price Index (CPI) rose 0.4% month-over-month and 3.4% year-over-year in August. Gasoline prices increased 3.9% over the month, accounting for more than one-third of the CPI’s overall monthly gain, while energy prices rose 2.1% month-over-month and 16.3% year-over-year.

Against this backdrop, the Fed raised its benchmark interest rate at the FOMC meeting on the 16th, marking its first increase in more than three years since July 2023, and said the move was intended to return inflation more rapidly to its 2% target. The Fed’s tightening stance is also exerting upward pressure on the U.S. Treasury market. The 10-year Treasury yield climbed above 5% on the 14th, immediately before the FOMC meeting, and again surpassed 5% following the meeting on the 16th. Commenting on the situation, one market expert said, “The U.S. government is being forced to accept elevated borrowing costs as the growing burden of Treasury issuance caused by war spending and fiscal deficits converges with oil-driven inflation,” adding, “Conditions in U.S. financial markets and investor sentiment will remain heavily dependent on the course of the Iran war for some time.”