Finance
Analysis-Treasury Market's Next Test: Rising War Costs
Published by Global Banking & Finance Review®
Posted on March 31, 2026
4 min readLast updated: March 31, 2026
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Rising costs from the Iran conflict—potentially over $200 billion in supplemental defense spending—and fallout from a Supreme Court tariff ruling raising up to $175 billion in refund liabilities are piling pressure on Treasury yields and could widen the U.S. deficit beyond 6 % of GDP.
Rising War Costs and Inflation Threaten US Treasury Market Stability
By Karen Brettell
Mounting Fiscal Pressures and Market Reactions
March 31 (Reuters) - Inflation risks have driven Treasury yields higher since the U.S. clash with Iran ignited energy prices. Now another threat to bond market health is coming into view: the cost of an extended conflict.
Wall Street continues to expect the war to end soon, easing pressure on both the price of oil and the U.S. purse. Even so, some analysts are toting up the tab for extended war-related defense spending, tariff refunds and a potential stimulus should the economy slow sharply. They say it could become an issue for markets that have recently become less friendly to bonds, with the S&P U.S. Aggregate Bond Index returning -0.6% so far in the first quarter.
Deficit Projections and Investor Concerns
BNP Paribas, for instance, expects the U.S. deficit to stay just below 6% of GDP over 2026 and 2027. Factor in the added costs, however, and “you get from a deficit that's just below 6% to something that could easily be closer to 8% or even a bit above," said senior economist Andrew Husby. That isn't a trend bond investors want to see.
Signs of Inflation Stress
The most intense bond market selling has so far been concentrated in short-term yields, reflecting fading hopes for near-term Federal Reserve rate cuts. But longer-dated yields have also climbed, with the 10-year Treasury briefly nearing 4.5% for the first time since last summer and some Treasury auctions this month drawing weak demand.
"All of these little costs seem to be adding up," said Bill Campbell, a portfolio manager at DoubleLine Capital.
Rising Debt and Defense Spending
The U.S. fiscal position was already stretched before the first U.S. strike on Iran on February 28. The national debt has reached a record $39 trillion, and annual net interest payments are expected to reach $1 trillion this fiscal year.
The Pentagon is seeking more than $200 billion in supplemental funding from Congress for the Iran war, which is on top of the roughly $900 billion defense bill already signed for fiscal year 2026.
The government's revenue position also took a hit after the Supreme Court ruled that the president cannot use emergency powers to impose tariffs, potentially requiring around $175 billion in refunds to importers. The administration has said it will impose replacement tariffs under separate legal authority, though it is unclear whether these will fully make up the lost revenue.
Market Expectations and Monetary Policy Risks
Not Leading Moves So Far
Markets so far aren't expecting large shifts in the U.S. fiscal outlook.
BNP’s Husby said markets may simply wait for actual legislation to take shape before reacting more forcefully. "There's not a ton of extra fiscal risk really being priced right now," he said.
Dirk Willer, head of macro and asset allocation strategy at Citigroup, said the biggest risk is that the Federal Reserve won't be able to cut rates due to inflation while fiscal expenditures are rising and the Fed is potentially looking to cut the size of its balance sheet.
Then, “you could see again the fiscal voice coming back to a larger extent.”
First Things First: Near-Term Threats
Nearer-term threats may be a Fed rate increase and rising geopolitical risk.
Robert Tipp, chief investment strategist and head of global bonds at PGIM Fixed Income, warned that "the other shoe to drop would occur if and as growth continues and inflation stays high and it turns out the U.S. is going to have a hiking bias or hike rates this year."
Christian Hoffmann, head of fixed income at Thornburg Investment Management, says years of geopolitical shocks that ultimately proved manageable have trained investors to underreact — a pattern that will likely hold until something breaks it. "We might be at the cusp of that right now," he said.
Potential Treasury Responses
If longer-dated yields do continue to rise, the Treasury's most likely response would be to alter its issuance strategy. Campbell of DoubleLine said a 30-year yield of 5.25%, up from a recent 4.95%, "would be a big problem" and could prompt the government to cut long-dated issuance in favor of short-term bills.
Mike Cudzil, a portfolio manager at PIMCO, sees the oil shock eventually slowing growth, forestalling rate hikes and potentially allowing the Fed to cut later this year — sending yields lower. PIMCO has been adding longer-dated debt across developed markets on that basis.
(Reporting by Karen Brettell; additional reporting by Vidya Ranganathan; editing by Colin Barr and Anna Driver)
Key Takeaways
- •Extended Iran war spending—Pentagon seeks $200 billion more—adds fiscal strain beyond existing defense budgets, risking a deficit rise toward 8 % of GDP.
- •Supreme Court’s invalidation of emergency tariffs under IEEPA creates up to $175 billion in potential tariff refunds, undermining projected revenues and cash flow.
- •Bond markets remain wary: weaker Treasury auction demand and rising yields reflect concern over inflation risks, delayed Fed easing, and accumulating fiscal shocks.
Frequently Asked Questions about Analysis-Treasury market's next test: rising war costs
1How are rising war costs impacting US Treasury yields?
Rising war costs are pushing Treasury yields higher by increasing fiscal deficits and inflation risks, making the bond market less attractive to investors.
2What is the outlook for the US deficit due to extended conflict?
Analysts suggest the US deficit could grow from just below 6% of GDP to 8% or more if war-related spending continues.
3How have recent events affected the bond market?
Recent events have led to higher short and long-term yields, with weak demand for some Treasury auctions and negative returns for bond indices.
4Why might the Federal Reserve be unable to cut rates soon?
Persistent inflation and rising fiscal expenditures may prevent the Federal Reserve from cutting rates as quickly as previously hoped.
5What could prompt changes in Treasury issuance strategy?
If long-term yields rise significantly, the Treasury may cut long-dated issuance in favor of more short-term bills.
