Borrowing costs are surging amid Iran war
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The Iran war is sending longer-term borrowing costs surging amid prospects for higher inflation, fewer Federal Reserve rate cuts and more federal borrowing.
Why it matters: Higher rates create new pressure for an already-faltering housing sector, make the U.S. government's fiscal challenges worse and could weigh on business investment and consumers alike.
- It contrasts with past geopolitical tumult, when money frequently flowed into Treasury securities as a safe haven.
Driving the news: The 10-year Treasury note yielded 4.45% at around 10:30am ET, up half a percentage point from 3.96% just before the U.S. and Israeli attack on Iran. It receded some and was at 4.42% by 11:45am ET.
- This week, three auctions of government debt showed weak demand for the securities, with two-, five- and seven-year Treasury notes commanding lower prices — and thus higher borrowing costs for the government — than anticipated.
- There has been an even more pronounced rise in mortgage rates. The average 30-year fixed-rate mortgage was 5.99% at the end of February, just before the war started, per Mortgage News Daily. It was up to 6.62% on Thursday.
Zoom out: Investors are pricing in somewhat higher inflation in the years ahead as oil and natural gas prices surge. But that's not the primary driver of the shift.
- The pricing of 10-year inflation-protected Treasuries implies inflation of 2.34% over the next decade, up only slightly from 2.25% pre-war.
- In other words, only about a fifth of the rise in the 10-year yield this month is accounted for by investors anticipating higher inflation.
- The rest is explained by the "term premium" — the compensation that investors demand for taking the risk of tying up their money for years.
Between the lines: That points to concern over the new volatility in Treasury securities, expectations of more federal borrowing to fund the war effort and greater uncertainty about what the future looks like.
- It could reflect technical issues in financial markets as well, such as hedge funds being forced to unload Treasuries to free up cash as other trades unraveled in this volatile month.
What they're saying: The last month has seen "enhanced volatility in the bond market as well as a rising risk premium that investors are charging to purchase U.S. Treasury securities," wrote Joe Brusuelas, chief economist at RSM.
- "Investors' concerns include an unsustainable American fiscal position, rising inflation risk and a growing uncertainty about war."
Of note: Traders have piled into bets over the last week or so that the Fed's next move will be to raise interest rates amid ongoing inflation, not cut them as has long been telegraphed.
- Futures now price in a 40% chance that the Fed's policy rate will be higher at year-end than it is now, per the CME FedWatch tool.
- That repricing has come despite no clear signals from Fed leadership that they're contemplating raising rates.
- On Thursday, vice chair Philip Jefferson said that uncertainty about the economy is "elevated" and that he sees the Fed's "current policy stance as appropriately positioned to" allow the Fed to wait and see how the economy evolves.
The bottom line: The prospect of a prolonged disruption to economic activity, higher federal borrowing and tighter money from the Fed, along with a more volatile backdrop, are making interest rates higher right now.
