War-driven tensions push U.S. Treasury yields sharply higher, with weakening demand shaking markets

Rising fears of collapsing Treasury demand heighten market anxiety
Oil-driven inflation pressures raise prospects of rate hikes
Expanding U.S. war budget intensifies fiscal strain

Tensions are rising rapidly in global bond markets as higher yields and shifting demand dynamics converge. With signs of reduced purchases by major holders such as Europe, China, and Japan unsettling markets, the impact of the Middle East conflict—through surging energy prices and shifts in monetary policy among major economies—has driven U.S. Treasury yields higher day after day. More recently, the expansion of U.S. war-related spending has further highlighted the link between fiscal burdens and financial market stability.

Demand concerns intensify

On the 19th, U.S. business outlet CNBC, citing Matthew Amis, director at Aberdeen Investments, reported that “a ‘perfect storm’ is looming in the bond market as global energy prices surge alongside signals of interest rate hikes from major central banks.” The outlet based its assessment on the continued upward trend in U.S. Treasury yields. In the market that day, the yield on the 10-year U.S. Treasury rose 0.024 percentage points from the previous session to 4.281%, while the more rate-sensitive 2-year yield surged 0.092 percentage points to 3.835%.

Signs of tension in the bond market began to emerge in earnest from January. Europe, amid diplomatic friction with the United States, considered selling U.S. assets including Treasurys, while China and Japan simultaneously strengthened domestically focused fiscal policies and moved to reduce their Treasury holdings. At the time, Bloomberg reported, “As Japanese Prime Minister Sanae Takaichi pushed expansionary fiscal policies, long-term Japanese government bond yields surged to unimaginable levels,” adding that “this is triggering a chain reaction of rising yields from the United States to the United Kingdom and Germany.” As yields in major economies rose in tandem, upward pressure spread across the broader bond market.

These trends are also evident in actual capital flows. Denmark’s largest pension fund, AkademikerPension, decided to sell its entire $100 million holding of U.S. Treasurys, citing the deterioration of U.S. fiscal health as the reason. Sweden’s state pension fund AP7, which manages more than $90 billion in assets, also announced plans to reduce its Treasury exposure while reviewing its portfolio in light of rising U.S. debt and political uncertainty. China’s holdings of U.S. Treasurys, meanwhile, fell to $682.6 billion as of November last year, marking the lowest level since September 2008.

More recently, there have also been cautious discussions about the potential withdrawal of countries asked by the United States to deploy naval forces to the Strait of Hormuz. President Donald Trump had earlier called on five countries—South Korea, Japan, China, the United Kingdom, and France—to support military operations against Iran. As of December last year, these countries collectively held $3.2445 trillion in U.S. Treasurys, accounting for more than one-third of the total outstanding amount of $9.2709 trillion. While the idea that these countries might sell Treasurys in response to military pressure remains largely speculative, even the possibility of a shift in stance among major holders is fueling demand concerns and tightening market tensions.

Inflation outlook revised upward

Inflationary pressures driven by rising global oil prices are also beginning to materialize. The so-called “Trumpflation” triggered by the Middle East conflict has intensified, with upward pressure on prices centered on energy. As a result, central banks that had been considering entering a rate-cut cycle are now reassessing their policy paths, prioritizing inflation control. While most countries have indicated that they could return to easing if the war shock subsides quickly, they also acknowledge that prolonged supply disruptions would necessitate a shift in policy direction.

The Bank of England (BOE) held its benchmark rate at 3.75% on the day. Markets had previously expected a 0.25 percentage point cut, but policy direction shifted abruptly following attacks on oil and gas facilities in the Persian Gulf. Although five of the nine members of the Monetary Policy Committee (MPC) had prepared for a rate cut, all ultimately voted to hold rates steady. The BOE has also left open the possibility of rate hikes if inflationary pressures persist. As a result, market expectations have been rapidly revised, with forecasts of rate cuts within the year effectively disappearing.

The European Central Bank (ECB) also held its benchmark rate at 2% while raising its inflation outlook. The eurozone inflation forecast for this year was revised up from 1.9% to 2.6%, while the growth forecast was lowered from 1.2% to 0.9%. These changes reflect the impact of the Middle East conflict, which drove European natural gas prices up as much as 35% at one point and pushed global oil prices to $119 per barrel. ECB President Christine Lagarde noted that “energy prices will have an immediate impact on short-term inflation,” emphasizing upward pressure on prices. Discussions within the ECB about potential rate hikes have also reportedly emerged.

The U.S. Federal Reserve has adjusted its policy stance in a similar direction. Following its two-day Federal Open Market Committee (FOMC) meeting on the 17th and 18th, the Fed held its benchmark rate at 3.5%–3.75%. Chair Jerome Powell stated that “rising energy prices are delaying the slowdown in inflation,” adding that “the possibility of rate hikes as the next step was discussed at this meeting.” In response, federal funds futures markets have begun to price in a 4%–6% probability of rate hikes within the year. Meanwhile, continued attacks on Iranian gas fields by the United States and Israel kept global oil prices fluctuating around $110 per barrel on the 18th.

Heightening tension between fiscal and monetary policy

Compounding the situation, the United States is facing an expanding burden from war-related spending. According to The Washington Post (WP), the U.S. Department of Defense recently requested more than $200 billion in additional funding from the White House to sustain the war against Iran. The funds are expected to be used to ramp up production of key precision-guided munitions depleted over the past three weeks by U.S. and Israeli operations. The WP noted that "the war, which began on the 28th of last month, is estimated to have cost more than $11 billion in its first week alone," adding that "a budget request far exceeding existing airstrike costs has been presented, sharply increasing the government's fiscal burden."

The issue is that U.S. defense spending is already elevated. Under the National Defense Authorization Act (NDAA), the defense budget for fiscal year 2026 stands at $901 billion, and in January prior to launching military operations against Iran, President Trump stated that he would increase next year's defense budget to $1.5 trillion. If additional war funding is incorporated, total fiscal expenditures will inevitably expand further. The U.S. government began preparing supplemental budgets immediately after the outbreak of the war, describing the move as "a procedure to maintain global military readiness."

There are also divided views on whether the Pentagon's budget proposal will pass Congress. Public opinion in the United States remains lukewarm toward the war, while the Democratic Party is increasingly raising criticism of the Iran conflict. Although Republicans have expressed support for additional funding, no concrete strategy has been presented to secure the 60 votes required for passage in the Senate. Reports that even within the White House the Pentagon's funding request is viewed as unrealistic have further fueled political tensions, turning the debate over additional funding itself into a source of conflict.

In this process, the linkage between war financing and the bond market has once again come into focus, intensifying the debate. It is pointed out that expanding Treasury issuance will be unavoidable to cover large-scale additional spending. Opponents of budget expansion warn that tensions between fiscal expansion and the interest rate path will deepen. With major holders already reducing their purchases, an increase in new Treasury supply would heighten demand-side pressure and further push yields upward. Fiscal policy tied to war costs is thus seen as an additional headwind for the Treasury market.