US bonds rally as 4% yield reflects shift from inflation to growth fears

The U.S. Treasury market is caught in a tug-of-war between stagflationary crosscurrents, with a two-day bond rally highlighting a subtle shift in focus from the inflationary shock of the Middle East war toward its potential to drag on global growth.

"The market is swinging between inflation panic, which sends yields up, and growth-slowdown panic, which sends yields down," said Win Thin, chief economist at Naso 1982 Bank. "This is the classic stagflation dilemma: there is no easy policy response, so the market can't decide whether to focus on the 'stag' or the 'flation'."

The benchmark 10-year Treasury yield fell to 4.33% on Tuesday, retreating further from an eight-month high of 4.48% set last week. The policy-sensitive two-year yield slipped to 3.82%, though it remains more than 40 basis points higher since the conflict began a month ago, reflecting deep uncertainty over the path of inflation.

The dilemma complicates the Federal Reserve's policy path, with markets now pricing out most of the rate cuts anticipated at the start of 2026. While Fed Chair Jerome Powell signaled a "wait-and-see" approach on Monday, persistent energy-driven inflation could force a hawkish response, even as the risk of a policy-induced slowdown grows. The next Fed meeting concludes on May 1st.

Oil Volatility Adds to Uncertainty

Driving the market's division is the price of oil, which has remained volatile above $100 a barrel, up from around $70 before the conflict started in late February. Prices jumped Tuesday on reports of an Iranian drone striking a tanker, but later pared gains after news that the U.S. president might be willing to end military action.

"Now that the reality is sinking in that perhaps the oil price might stay high for a bit longer... the growth impact is starting to become more of a focus," Moh Siong Sim, a strategist at OCBC, said in a note. This view was echoed by Nomura strategist Andrew Ticehurst, who noted that after an initial focus on inflation, "the market is starting to consider more of the downside risks to growth."

Foreign Demand for Treasurys Wanes

The conflict is also reshaping global capital flows. Custodial holdings of U.S. Treasurys, a proxy for foreign official demand, have fallen by $66 billion since the start of March to their lowest levels since 2012, according to BofA Securities.

Strategists at the bank noted that Middle East oil exporters, who hold over $300 billion in U.S. government debt, may be selling assets to raise cash. "It’s more about a lot of uncertainty in risk markets and a demand for liquidity," said Thomas Simons, a money-market economist for Jefferies. This dynamic challenges the traditional view of Treasurys as a primary safe haven during geopolitical turmoil. The last time a similar supply-side shock occurred during the initial phase of the COVID-19 pandemic, Treasury yields also rose initially before central bank intervention stabilized markets.

The shift in sentiment has been rapid. At the start of 2026, money markets were pricing for the Fed to continue its rate-cutting cycle. Now, those expectations have been replaced by a consensus for rates to remain on hold, with a non-trivial probability of a hike later this year.

This article is for informational purposes only and does not constitute investment advice.