Since the Iranian conflict began in late February, bond yields have risen sharply due to investor expectations of inflation spikes. Recent inflation data shows those rising inflation expectations are somewhat justified, with monthly inflation rates rising by 0.86% in March and 0.64% in April, translating to inflation running in the high single digits on an annualized basis. However, analysis reveals a significant disconnect between market reactions and actual inflation expectations. The 5-year UST yield has risen by nearly 70 basis points since the war started, while 5-year inflation expectations have increased by only 15 basis points. This disconnect is particularly notable because inflation expectations are not survey responses or best guesses - they measure actual money being put to work in the markets, providing concrete evidence of investor positioning rather than speculation.
The disconnect between yields and inflation expectations has created a notable shift in real yields. As reported by Investing.com, the 5-year real yield is up by about 55 basis points since the conflict started, indicating that the recent increase in yields is not primarily driven by rising inflation expectations but rather by recency bias. Investors are fearing that high inflation rates from several years ago are about to recur, leading to bond selling as protection against potential price increases. While this fear may be understandable given historical context, the reality is that the market is not pricing in future inflation in line with the market reaction.
The bond market disconnect has broader implications beyond domestic inflation concerns. According to Business Standard, interest rates on a 10-year US Treasury note are topping 4.44%, up from 3.95% before the war started at the end of February. The challenge is global in scale, as interest rates have risen for multiple countries as the world has been adjusting to the prospect of higher inflation. Average mortgage rates have climbed to their highest levels in nine months, while auto sales are slumping due to the increased borrowing costs. The disconnect is particularly concerning for President Trump's midterm election prospects, as higher interest rates provide Democratic candidates with additional attack lines against Republican incumbents.
According to analysis from Investing.com, the market is not pricing in future inflation in line with current reactions. The extra yield known as the term premium will likely normalize when oil prices fall and inflation expectations cool, suggesting that the current disconnect between yields and expectations may not be sustainable. When Kent Smetters, faculty director of the Penn Wharton Budget Model, broke down the math tied to rising 30-year Treasury yields, he estimated that 60% of the increase had come from the expectation that America will continue its outsized borrowing and the other 40% was tied to the inflation driven by the Iran war and Trump's tariffs. This expectation indicates that the red and blue lines measuring yields and inflation expectations are likely to converge as market conditions stabilize.
