(Bloomberg) - Even before last weekend, Pacific Investment Management Co.’s Daniel Ivascyn was preparing for turbulence.
With AI-related jitters reverberating through markets and private credit tremors setting off alarms, the chief investment officer at Pimco and manager of the world’s largest active bond fund was making adjustments — reducing corporate credit and stockpiling cash-equivalent holdings that could be quickly sold to take advantage of any dislocations, while still favoring medium-dated Treasuries.
“Then a war breaks out in the Middle East,” Ivascyn said in an interview, “and now you have additional concerns.”
Just as investors closed their books on a month when mounting concerns over corporate risks fueled demand for the perceived safety of Treasuries, the US-Israeli attack on Iran raised a whole new set of worries — and triggered a different response.
Instead of acting as a refuge, US government bonds took their cue from surging crude prices and yields shot up, with inflation fears taking center stage at a time when prices are already running higher than central banks would like. “That’s the type of tension in terms of markets that we have seen in the last few days,” Ivascyn said.
Then at week’s end, a report showing a surprise drop in US payrolls added yet another cross-current to the mix, and raised the specter of stagflation.
As hostilities in the Middle East grind on for a second week, the human toll and geopolitical ramifications of the war remain of paramount concern. But for investors in the $31 trillion US bond market, the conflict has also served to complicate a defining trade for 2026 that had seemed straightforward: collect interest of around 4% and wait for the Federal Reserve, under its incoming chair, to resume cutting interest rates. While that strategy is still working, risks are on the rise, with more spinning plates to juggle.
‘Serious Move’
The unfolding conflict has forced some of the world’s largest asset managers to reassess their assumptions and investment strategies. Investors now face the risk that rising oil prices repeat past episodes and deliver the one-two punch of inflation — the scourge of bonds — followed by a hit to growth.
“The market is thinking about inflation and this is a serious move in oil,” said Bhanu Baweja, chief strategist at UBS. “If the oil problem persists, it’ll become a growth problem.”
With inflation stubbornly stuck above the Fed’s 2% target, traders had been scaling back expectations for cuts this year even before the conflict started, while pushing bets for deeper easing into 2027 should a slowdown eventually materialize. The fast-escalating war and threat of energy disruptions prompted some traders to bet on no cuts at all in 2026, though Friday’s employment report pushed the consensus back closer to expecting as many as two quarter-point cuts this year.
Until a ceasefire materializes, the Treasury market is likely to be torn between near-term inflation fears and the risk of economic deceleration later in the year. The result is a highly uncertain outlook as the market weighs growth versus inflation. That push and pull has already kept 10-year Treasury yields — the global benchmark for borrowing costs — in a tight band of roughly 4% to 4.5% for more than a year.
“The market’s sort of stuck in this half-in, half-out situation where there’s a lot of risks,” said George Catrambone, head of fixed income at DWS Americas.
Worries about the war have sidelined other concerns that had gripped the market in recent weeks around private credit risks and the disruptive — potentially disinflationary — impact of artificial intelligence. But those issues aren’t going away. A report due this week is expected to show headline inflation ticked up in February, before any of the hostilities even happened.
“The danger of this whole episode is there are some significant questions that were swirling around with respect to private credit and AI going on in the background,” Catrambone said. “Markets are probably not paying attention to those as much as they should.”
Treasuries may end up regaining their haven status, particularly if signs point to an economic downturn. For now, though, there is a greater risk of stagflation — a period of sticky inflation and sluggish economic growth that would pose a nightmare scenario for central bankers and investors.
“There is this tension between the weakening of the labor market and the near term inflationary move coming out of the oil price,” Jeffrey Rosenberg, senior portfolio manager at BlackRock Inc., told Bloomberg TV. “The longer or the stronger the oil price increases, you bring about demand destruction and that makes the Treasury market move on the knife’s edge.”
War Costs
Kevin Flanagan, head of investment strategy at WisdomTree, favors owning a mix of short-dated, floating-rate Treasuries and debt in the six-year area of the curve, in what he calls a “bar-bell approach” where “you are not putting your chips on where rates are going to go.”
If the war drags on, the costs threaten to add to a US deficit that is already a source of worry for bond investors as it may lead to more Treasury issuance.
“Armed conflicts are expensive and the longer the operation runs, the greater concerns will grow regarding the ability of the Treasury Department to fund it without ultimately needing to increase auction sizes,” said Ian Lyngen, head of US rates strategy at BMO Capital Markets.
Some long-term investors are sticking to their approach, arguing that geopolitics, AI, fiscal policy and the transition to a new Fed chair will likely keep the 10-year yield at 3.75% to 4.25%.
If it rises to the upper end of that range, Vanguard’s Roger Hallam, global head of rates, said he would look to buy.
“The AI disruption theme will be ever present with us,” Hallam said, noting that steady long-term inflation expectations suggest markets still see technology as a medium-term constraint on prices.
Still, Jack McIntyre, portfolio manager at Brandywine Global Investment Management said the risk of higher inflation mixed with weaker growth remains a “fat tail” that investors can’t ignore.
As for Pimco’s Ivascyn, he said the firm remains “on standby,” ready to swoop in as a buyer should any credit disruptions crop up, and maintains a “slight preference” for the intermediate area of the Treasury curve. Longer term, he says US 10-year notes offer value at current yields of about 4.1%, given current rates of inflation.
“With so much uncertainty, you’ve still got a decent real yield,” Ivascyn said.
By Michael MacKenzie
With assistance from Ye Xie and Miles J. Herszenhorn
