Stagflation, deficits, and hedging: US bonds encounter complex trading predicaments, Wall Street's investment logic shifts from interest rate cuts to warfare.

Two weekends ago, due to the spread of tension related to artificial intelligence in the market, the turbulence in private credit also raised alarms. Daniel Ivascyn, Chief Investment Officer of The Pacific Investment Management Company (Pimco) and manager of the world's largest actively managed bond fund, was making adjustments - reducing company credit and hoarding cash equivalents for quick sale in case of any market dislocations, while still favoring mid-term US Treasury bonds. In an interview, Ivascyn said, "And then the Middle East erupted in war, and now you have a little more concern." Last month, investors seeking refuge in US Treasuries due to growing concerns about corporate risk. Currently, the US and Israel's attacks on Iran have sparked different market reactions. Instead of serving as a safe haven, US Treasuries have been affected by the sharp rise in oil prices, leading to a significant increase in yields, with inflation concerns becoming a focal point of the market's attention, even as price levels have already exceeded the expectations of major central banks. Ivascyn stated, "That's the market turmoil we have seen in the past few days." Subsequently, a report showing an unexpected decrease in US nonfarm payrolls added another undercurrent to the situation and raised concerns about stagflation in the US. As the conflict in the Middle East enters its second week, the casualties and geopolitical impacts of the war remain the most concerning issues. However, for investors in the US bond market, which has a scale of $31 trillion, this conflict has made a seemingly simple key trade in 2026 more complicated: investors previously expected to receive about 4% interest and then wait for the Fed to lower interest rates under the new chairman's leadership. Although this strategy is still effective at the moment, the risks are rising, and there are more factors to consider. During the Monday Asian trading session, the yield on the 10-year US Treasury bond climbed to 4.19%, marking a slight increase since the beginning of the year. Rising oil prices impact interest rate outlook This escalating conflict has forced some of the world's largest asset management firms to reassess their assumptions and investment strategies. Investors are currently concerned about inflation, and the significance of the oil price's move cannot be ignored. If the oil issue continues, it could evolve into an economic growth issue. Bhanu Baweja, Chief Strategist at UBS, stated, "The market is focusing on inflation, and the move in oil prices is significant. If the oil problem persists, it will evolve into an economic growth problem." With inflation persisting above the Fed's 2% target, traders had already lowered their expectations for interest rate cuts before the conflict erupted, while also betting that if the economy slows down, the Fed will further ease monetary policy in 2027. The rapidly escalating war and the threat of energy supply disruptions have led some traders to bet that there will be no rate cuts in 2026, but the nonfarm payroll report last Friday led to widespread expectations that there might be two rate cuts this year, each by 25 basis points. Until a ceasefire agreement is reached, the US bond market is likely to swing between short-term inflation concerns and the risk of slowing economic growth in the latter half of the year. As the market balances between growth and inflation, the outlook is highly uncertain. This tug-of-war has kept the 10-year US Treasury bond yield (the benchmark cost of global borrowing) within a narrow range of about 4% to 4.5% for over a year. George Catrambone, Head of Fixed Income at DWS Americas, stated, "The market is currently in a half-in, half-out state, with many risks present." Concerns about the war temporarily overshadowed other issues that the market had been focusing on in recent weeks, such as risks in private credit and the disruptive impact that artificial intelligence could bring (which might even lead to deflation). These problems will not disappear. It is expected that the CPI report to be released this week will show a slight increase in overall inflation rates for February, even before any hostile actions occurred. Catrambone said, "The danger in all this is that some major issues surrounding private credit and artificial intelligence have been quietly brewing in the background. The market may not have paid the necessary attention to these issues." If signs of a US economic recession become apparent, US Treasuries could eventually regain their safe-haven status. But at present, the risk of stagflation is greater - stagflation refers to a period of persistently high inflation and weak economic growth, which would be a nightmare for central bank investors. Jeffrey Rosenberg, Senior Portfolio Manager at BlackRock Group, said in an interview, "There is a tension between a soft labor market and short-term inflation brought about by rising oil prices. The longer and more intense the rise in oil prices, the more likely it will lead to demand contraction, putting the US bond market in a precarious position." War costs may raise US fiscal deficits Kevin Flanagan, Head of Investment Strategy at WisdomTree, tends to hold a combination of short-term floating rate US Treasuries and 6-year bonds, which he calls a "barbell strategy," where "you are not betting on the direction of interest rates." If the war continues, its costs may exacerbate the US fiscal deficit, which has already concerned bond investors as it could lead to more US Treasury issuances. Ian Lyngen, Head of US Rate Strategy at BMO Capital Markets, said, "Armed conflict is costly, and the longer it lasts, the more people worry about whether the US Treasury will have the ability to fund itself without increasing auction sizes in the end." Some long-term investors stick to their investment strategies, believing that geopolitical, artificial intelligence, fiscal policy, and the change of leadership at the Federal Reserve might keep the 10-year US Treasury yield held within a range of 3.75% to 4.25%. If prices rise to the upper end of that range, Roger Hallam, Global Rates Manager at Vanguard Group, said he would consider buying. "The disruptive theme of artificial intelligence will stay with us," Hallam said, noting that stable long-term inflation expectations indicate that the market still sees technology as a constraint on medium-term prices. However, Jack McIntyre, Portfolio Manager at Brandywine Global Investment Management, stated that the risk of rising inflation combined with slowing economic growth is still a tail risk that investors cannot ignore. As for Pimco's Ivascyn, he stated that the company is still on standby and ready to act in case of any credit crisis while still "slightly favoring" the midsection of the US Treasury yield curve. Looking long-term, given the current inflation rates, he believes the 10-year US Treasury bond has investment value at the current yield of around 4.1%. Ivascyn said, "Despite the many uncertainties, real yields are still quite attractive."