Original author: Zhao Ying

Original source: Wall Street Journal

The global bond market stands at a historic turning point. The surge in oil prices triggered by the conflict in the Middle East and the warming of inflation expectations are pushing U.S. Treasury yields to their highest levels in twenty years and triggering a chain sell-off in major markets such as the UK and Japan, heralding the quiet onset of a new era of persistently high interest rates.

The yield on the U.S. 30-year Treasury bond has climbed above 5%, marking a new high since 2007, while demand at last week's 30-year Treasury auction was lukewarm, failing to inspire buying enthusiasm even at such high levels. Meanwhile, market expectations for the Federal Reserve's policy path have fundamentally reversed, with traders now viewing a rate hike in March next year as highly probable, and the likelihood of a rate hike by December at about three-quarters, whereas at the end of February this year, the market expected two rate cuts in 2026.

This turmoil in the bond market has weighed on the stock market and garnered significant attention from the G7 finance ministers, who will discuss this round of bond sell-off at their meeting this week. Priya Misra, a portfolio manager at J.P. Morgan Asset Management, warned that "long-term rates are rising synchronously around the world, often reinforcing each other, and the expectation of rate hikes by the Fed is entering the market narrative."

Iran War Turns the Bond Market Narrative

The blockade of the Strait of Hormuz is the core driving force behind this wave of turbulence in the bond market. This globally crucial oil transport route being blocked is continuously raising oil prices and reigniting inflation expectations.

Investors generally believe that as long as the standoff in the Middle East is not resolved, the pressure in the bond market will be difficult to dissipate. Priya Misra stated bluntly, "Unless the strait reopens, the interest rate range has overall shifted upward."

From the data, the current yield on U.S. Treasuries is approximately 50 basis points or more above the level at the end of February. The 2-year yield briefly rose to 4.09%, the highest since February 2025; the 10-year yield stands at 4.58%, the highest it has been in nearly a year. So far this year, U.S. Treasuries have recorded negative returns overall, whereas at the end of February the annual gains had approached 2%.

Inflation Narrative Dominates Market Pricing

The core concern in the market right now is the re-anchoring of inflation expectations. Karen Manna, fixed income strategist and portfolio manager at Federated Hermes, stated, “We are seeing a world that is truly grappling with a new round of inflation.”

WisdomTree's head of investment strategy, Kevin Flanagan, expects that the next Consumer Price Index report may show an annual inflation rate reaching 4%, marking the highest level since 2023—April's CPI recorded 3.8%. He pointed out, "The inflation narrative is dominating the market, and the bond market is requiring a higher premium for holding newly issued government bonds."

The persistent concerns about the expanding U.S. fiscal deficit, along with signs that the economy remains resilient in the face of wartime headwinds, further reinforce the logic for investors demanding higher term premiums. Last week's Treasury auction confirmed this: the rate at the 30-year auction reached 5%, the highest since 2007, but demand was tepid; demand for 3-year and 10-year auctions was similarly lukewarm.

Rate Hike Expectations Reshape Federal Reserve Outlook

This inflation storm is also putting immense pressure on the incoming Federal Reserve Chairman Kevin Warsh, causing market bets on rapid rate cuts following his appointment to falter.

Chicago Fed President Austan Goolsbee stated last week that widespread price pressures could even signal an overheating economy; Fed Governor Michael Barr referred to inflation as the "overwhelming" risk facing the economy. The minutes from the Fed's April meeting will be released this Wednesday, and the market will closely monitor how much support dissenting members received from officials.

In the latest J.P. Morgan Treasury Investor Survey, short positions in Treasuries reached their highest level in 13 weeks, indicating a noticeable increase in market bets on further declines in the bond market.

Investors Wait and See, Awaiting More Signals

Faced with ongoing selling pressure, some investors have chosen to remain on the sidelines. Kevin Flanagan stated that he is currently sticking with floating-rate notes and maintaining a low interest rate exposure, saying, "It's better to buy late than to buy too early. He believes a 10-year yield at 4.5% is "more of a psychological barrier," and if the situation in the Middle East escalates again raising oil prices, yields may retest last year's high of 4.62%."

Hank Smith, head of investment strategy at Haverford Trust, takes a more cautious stance, stating that whether the rise in consumer and producer prices is temporary or will extend into 2027 remains an open question, needing more data to judge the direction of the bond market.

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