Key Highlights

• Treasurys are not behaving as expected during geopolitical turmoil.
• Their safe-haven properties have waned since the pandemic.
• Higher mid-month funding spreads likely reflect increased UST settlements.

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The curious case of rising yields amid geopolitical risk

EXHIBIT #1: RATE EXPECTATIONS STEADY

_{Source: BNY Markets, Bloomberg}

EXHIBIT #2: UST SAFE-HAVEN PROPERTIES FADE

_{Source: BNY Markets, Bloomberg}

As of this writing, market reaction to hostilities in the Middle East has been either muted or, in some cases, counter to expectations. Typically, after a geopolitical shock of this nature, market volatility rises and risk assets like equities and corporate bonds weaken. In addition, the dollar would appreciate and U.S. government bonds would rally, reflecting flight to safety behavior. In some cases, such as the dollar, price action has followed the usual playbook. The USD rallied by just under 1% on Monday, and equities sold off by around 1% at the open.

The real perplexity lies in the move in U.S. Treasurys. We would expect them to rally and yields to fall, but that is the opposite of what we saw on the first trading day after the air strikes. The 10y yield is up over 10bp, after starting the New York trading day below 4%. The 30y has moved about the same amount, but closer in on the curve, the 2y is up even more, threatening 3.5% – nearly 15bp higher.

The intuition that would appeal suggests that higher oil prices – especially for an extended time – would engender inflation, or at least de-anchor inflation expectations. Relatedly, policy rates would be expected to be higher than previously foreseen, had there not been an oil shock. But that doesn’t square with what we see in the futures market. Exhibit #1, which shows OIS-implied December 2026 and 2027 fed funds futures, indicates there has been no material move higher. If anything, as seen in the longer contract, rates next year could be slightly lower. Indeed, oil prices are only marginally higher after the conflict began. Furthermore, while the 10y yield is up a little over 10bp at this writing, breakeven inflation from the TIPS market increased by less than 3bp on Monday.

While it’s only been one day of market activity, we still grapple with this reaction in both bonds and equities (which as mentioned were close to flat on the day). Our best explanation is that the market seems hopeful that hostilities will last only for a few days, although we have no visibility on this. A more prolonged conflict could rattle markets and prompt a more intuitive risk-off response. Without an analogous rise in inflation expectations, the increase in yields suggests an increase in risk premia for USTs, something that is counter to the geopolitical playbook.

The current rise in yields exposes a phenomenon we have been observing since the end of the pandemic. The safe-haven appeal of U.S. Treasurys has waned somewhat. Exhibit #2 shows that in the years before 2020, bond yields moved in the opposite direction of equity volatility. Higher volatility led to lower yields – clear safe-haven behavior. The regression line through over 100 observations of these variables slopes downward. This is one way to demonstrate USTs’ risk-off appeal. In the right-hand panel, we look at the same indicators (light blue) and see essentially no relationship at all. A regression line through the dots is almost flat, indicating a zero coefficient. In other words, changes in the VIX do not feature a regular pattern of responses in 10y yields.

Are bonds losing their safe-haven properties? The same thing (higher VIX, higher yields) occurred in April last year during the post-“Liberation Day” fallout. There seems to have been a break in the pre-COVID relationship between bonds and equities, at least during stressful events. It is possible, however, that if the conflict grinds on for more than a few days, risk aversion will increase and bonds reassert their typically expected relationship to risk. 

February mid-month funding strains due to large UST settlements

EXHIBIT #3: LARGER SETTLEMENTS MEAN HIGHER FUNDING SPREADS

_{Source: BNY Markets, Bloomberg, U.S. Treasury}

February featured some unusual mid-month volatility in funding rates, with the tri-party general collateral rate (TGCR) trading 7bp over the interest rate on reserve balances (IORB) on April 18, and SOFR 9bp over the effective federal funds rate. The New York Fed’s daily Standing Repo operation (SRP) lent over $30bn in funding on that day, indicating some strain. While less acute, Monday, March 2, featured additional tightness in funding markets, with SRP lending $9bn in the afternoon.

We’re tempted to explain the most recent episode as a “hangover” from the normal end-of-month pressure we’re accustomed to. However, it should be noted that Treasury settlements on March 2 were large – just under $60bn in coupons, one of the largest settlements so far this year. This puts pressure on liquidity in funding markets and suggests that reserves are still just about ample. Settlements subtract from reserves, tightening liquidity. Indeed, we can see all the settlement dates so far in 2026 and note that funding spreads widen on such dates (Exhibit #3).

Rates outlook

Against the backdrop of current geopolitical events, we don’t alter our view for three rate cuts in the second half of the year. The market’s rates curve hasn’t materially moved since the attacks began – with two cuts for the year, even with slightly higher (for the moment) oil prices and a small concomitant increase in inflation expectations on the day.

Inflation last week, in the form of producer prices, was disappointingly high, driven largely by services – especially trade services, which is a proxy for margins. As firms pass on higher prices due to tariffs, their margins should rise, and this subcategory of the PPI increased by 4.2%.

Our rate call, however, rests on our concern over the labor market, which we note is at best flat and could be in for another turn lower. Even in a sticky inflation world, we think that if the labor market deteriorates further, the FOMC will address that with looser policy at the expense of inflation. This could have the related effect of raising long-end yields, even as front-end yields would likely fall, resulting in a steeper curve.

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