For Bonds, a Tug of War Between Rising Inflation and Slowing Growth

Heading into the second quarter of 2026, the bond market is being pulled in two directions. The threat of higher inflation resulting from the Iran war has investors thinking that major central banks could raise interest rates. At the same time, ripples from the war threaten to slow economic growth.

During the first quarter, inflation fears dominated, sending yields higher and prices lower. The yield on the US Treasury 10-year note finished the quarter at 4.3%, up from 4.2% at the start of the year.

Overall, the main US bond categories lost money—even inflation-protected Treasuries, whose rising rates can outweigh their inflation-adjustment benefits. The worst performers were long-term core bonds, followed by high-yield bonds, as worries about the impact of artificial intelligence and the Iran war made investors risk-averse. That said, credit-sensitive portions of the bond market have been resilient, even with the amount of uncertainty hitting the financial markets.

Despite expectations that the war won’t last much longer, the short- and long-term impacts remain highly uncertain. Where bonds go from here depends on how the balance plays out between inflation and slowing growth.

“We have seen a much larger move in the rates markets compared to the credit markets thus far. I think the rates market is worried about near-term inflation and the Fed being on pause, or raising rates, for longer now,” says John Lloyd, global head of multi-sector credit at Janus Henderson Investors. “Neither the rates market nor the credit market is putting a high probability on a prolonged conflict, growth downgrades, and recession.”

Expectations Grow for Rising Interest Rates

In the rates market, which is focused on interest rate risk and macro factors, the market has toyed with the prospect of a possible rate increase this summer in response to war-related inflation and the disruption of key supply chains.

In the US, two-year Treasuries recently yielded 3.82%. That’s above the 3.50%-3.75% federal funds rate but down from 3.96% the previous week, after Fed chief Jerome Powell said at a March 30 Harvard talk that the Fed is inclined to take a “wait and see” approach, and that “the tendency is to look through” an oil price shock as long as inflation expectations remain anchored. The Fed kept its rate in the 3.50%-3.75% range throughout the first quarter after lowering rates three times from a starting range of 4.25%-4.50% in 2025.

The market entered the year anticipating rate cuts, but those expectations have been pushed out to 2027, explains Hong Cheng, head of fixed income and currency research at Morningstar Investment Management. In the interim, rate increases could curtail future growth.

Expectations of rate hikes are even more drastic overseas, which will affect prospects for US companies operating there. In the Eurozone, average two-year sovereign yields are at 2.6%, sharply higher than the 2.0% of the ECB deposit rate. “The global sovereign debt market is signaling that the Eurozone, Japan, and the UK have a more significant issue with respect to oil-price-driven inflation than the US,” writes Datatrek Research.

What could offset rate increases? Strong flows in the bond market and good value for investors, according to Baird Asset Management co-CIO Warren Pierson. “Flows in the short run will mitigate the upward pressure on interest rates. Rates now look really attractive to yield-starved investors, compared to where they once were,” he says. In late 2021, for example, the 10-year yield was 1.5%. February saw a massive inflow to US bond funds, according to Morningstar data.

“This is a tough topic for the market,” says Cheng. In the last oil shock of 2022, “the labor market and economy were in better shape, which made the Fed’s decision to hike a lot easier. This economy is less resilient. That’s why you’re seeing different signals from different parts of the market. The expectations shift really quickly.”

While Rate Markets Swing, Credit Markets Stay Stable

Yet the credit markets, which are more focused on corporate defaults, have been relatively stable despite growth concerns. On March 30, the ICE BofA Corporate Index spread over Treasuries was at 0.91 percentage points, versus 0.86 when the war began. Meanwhile, the spread on the ICE BofA High Yield Index was 3.46 points higher than comparable Treasuries, versus 3.12 when the war began.

“I’ve actually been surprised on the credit side with how orderly things have been,” says Lloyd of Janus Henderson. He compares this sedate reaction to the days following April 2, 2025, when US President Donald Trump announced sweeping tariffs. In response, the investment grade spread widened to 1.20 percentage points and the high-yield spread to 4.61 points. Lloyd says that credit market investors, like stock market investors, have been conditioned to look past policy noise.

If a conflict extends to the year’s end or the next year, it would be “a major growth tax in the longer term,” says Lloyd. Ratings agencies would start downgrading credit ratings, which would expand yield spreads. Worries that pre-dated the Iran war would also persist, including weakness in private credit and AI’s effects on company business models. In such a scenario, Lloyd thinks high-yield spreads, now at 3.46 percentage points, could widen to 4.50-5.00 points. Meanwhile, the spread on the investment-grade index could jump to 1.2 points.

In Q1, Bonds Lost Money

In the first quarter, the main US bond categories lost money—even inflation-protected Treasuries. The worst performers were long-term core bonds, followed by high-yield, as worries about AI and the Iran war hit prices and made investors wary of investing in risk.

True, bonds beat the 6%-plus decline for equities, but this isn’t what investors want. During the last oil crisis in 2022, both bonds and equities suffered. “Cash is the only true safe haven in an inflation-driven shock,” says Morningstar’s Cheng.

“The sharp rise in interest rates in March canceled out strong February returns,” says Pierson of Baird. “The rally in bonds in the last couple days of March made things better. Despite the volatility and a disappointing first quarter, investors can still see the value in the overall level of interest rates.”