The war combined with massive deficits, the myth of U.S. debt safe-haven is quietly shaking

The safe-haven demand triggered by the Iran conflict has not, as in the past, driven funds into U.S. Treasuries. Instead, the inflationary shock brought by the war combined with the structural expansion of the U.S. fiscal deficit is weakening the hedging effectiveness of U.S. debt as a global “safe-haven asset.”

According to The Wall Street Journal, U.S. stocks closed slightly higher on Monday, continuing the market’s inertia of “buying dips” after sudden negative news. However, the bond market performed poorly, with yields on both short- and long-term U.S. Treasuries rising steadily since the market opened on Monday, indicating that Treasuries failed to provide traditional buffers under pressure.

Risk asset volatility is primarily reflected overseas. Last year, South Korea’s main stock index, the best performer globally, rose 92% cumulatively, but amid fears of war spillover effects on the economy, overnight declines reached their largest since 2008. U.S. stock futures initially plunged but turned higher before the market opened.

Factors driving U.S. Treasury weakness include concerns about re-inflation from rising oil prices and the continued squeeze on U.S. fiscal space. The Congressional Budget Office last month raised its deficit forecast for the next decade by $1.4 trillion, prompting investors to reassess the boundaries of “risk-free” pricing.

The safe-haven logic is challenged, and the role of Treasuries as shock absorbers is failing.

Investors are willing to accept lower returns on U.S. Treasuries mainly because they typically serve as “shock absorbers” during risk events. Under normal circumstances, if the stock market drops 10%, a bond rally of about 3% can keep the classic 60/40 stock-bond portfolio loss within 5%.

But this time, bonds failed to rally as expected. Long-term U.S. bond ETFs fell 1% on Monday and continued to decline on Tuesday, while stocks only began to fully price in the possibility of prolonged conflict afterward. This “stocks stabilize first, bonds fall first” pattern challenges the hedging logic itself.

Oil prices push inflation higher, making it harder for central banks to cut rates.

Persistent oil price increases will boost inflation, prompting investors to demand higher yields and thus lowering bond prices. Even if energy shocks may slow growth and traditionally lead to rate cuts, policymakers might respond more cautiously.

According to The Wall Street Journal, concerns about a replay of 1970s stagflation may cause central banks to be reluctant to cut rates easily amid energy shocks.

This contrasts with typical responses after non-energy shocks, where bonds tend to rebound significantly following events like 9/11, Lehman Brothers’ collapse, or Brexit. In the context of Iraq’s invasion of Kuwait in 1990 and soaring oil prices triggering a recession, bond prices also initially came under pressure.

High deficits exacerbate the vulnerability of the bond market.

Oil prices may not be the only variable. The U.S. fiscal situation was already strained: the Congressional Budget Office last month raised its deficit forecast for the next decade by $1.4 trillion. The federal deficit as a share of GDP has reached levels rarely seen since World War II during non-recession periods.

Meanwhile, the amount of U.S. debt held by the public is about to surpass the thresholds set during WWII. Back then, “public” mainly meant U.S. domestic savers; today, a significant portion is held by overseas creditors from the Middle East and Asia, who may worry about the conflict’s impact on their own economies.

Under this structure, U.S. Treasuries need to demonstrate their attractiveness to global funds, increasing sensitivity to interest rates and exchange rates.

Historical lessons: rising yields during the Vietnam War, difficulty replicating WWII-style “low interest rates”

Historical experience suggests that war combined with fiscal expansion does not always favor Treasuries. Even during the Vietnam War, when reliance on overseas financing was lower, yields rose as Washington simultaneously pursued “war on poverty” and actual warfare.

The reason U.S. Treasury yields remained moderate during WWII, as the Wall Street Journal notes, was due to the Treasury and Federal Reserve working together to suppress yields, at the cost of diluting savers’ returns.

However, in today’s era of free capital movement, concerns about a repeat of “fiscal dominance” could unsettle markets and weaken the dollar.