Treasury yields surge as Iran war revives Fed hike bets
Escalating military strikes in Iran have sharply increased the odds of a Federal Reserve rate hike next week, pushing U.S. Treasury yields to their largest weekly gain since May.
U.S. Treasury yields retreated slightly from 18-month highs on Friday but are poised for their largest weekly increase since mid-May as traders abruptly repriced the likelihood of a Federal Reserve rate hike. Fed funds futures now assign a 36% probability to a rate increase at the conclusion of the central bank's Wednesday meeting, a sharp jump from just 13% a week ago.
The benchmark 10-year yield fell 1.98 basis points to 4.683% on the day, logging a weekly advance of 14 basis points. The 2-year yield, which closely tracks near-term policy expectations, dropped 2.94 basis points to 4.331% but notched a 16-basis-point gain for the week. The shift pushed the yield curve between the two maturities to 34.8 basis points.
The sudden repricing stems from a rapid deterioration in the Middle East. U.S. missiles struck targets across Iran, reaching the Caspian coast, after President Donald Trump promised "major military punishment" for Iran and its Houthi allies expanding the conflict to a second major shipping chokepoint at the mouth of the Red Sea.
The military escalation erased the rate-cut optimism that followed a U.S.-Iran peace deal last month. Rising oil prices tied to the conflict have revived fears of stubborn inflation. "The reheating of the situation in the Middle East really got the market back on track to recognize there is a structural level of inflation that's too high, that's going to require higher rates," said Robert Tipp, chief investment strategist and head of global bonds at PGIM Fixed Income.
Price pressures are expected to be further compounded by new U.S. tariffs of 10% and 12.5% on goods from 60 trading partners, including the EU and China, which replaced an expiring temporary 10% global tariff. While June consumer price data showed inflation moderating faster than expected, a resilient economy is limiting the Fed's flexibility to look past energy-driven price shocks.
Services sector activity accelerated in July, supported by FIFA World Cup and Independence Day spending. Additionally, new single-family home sales snapped a two-month decline in June, though elevated mortgage rates continue to sideline potential buyers. Fed Chairman Kevin Warsh's preference for less forward guidance is amplifying market uncertainty. Futures currently price the benchmark rate reaching approximately 4.20% by April, up from the current 3.50% to 3.75% target range.
