The war that could break America’s borrowing machine

THERE is a structure that underpins almost every major financial decision. It is not on Wall Street, nor in the City of London. It is the US Treasury market – a US$30 trillion ocean of government bonds that serves as the world’s financial bedrock.

It enables pension fund managers to sleep soundly. Central banks hold its securities in their reserves. Mortgages, corporate loans, even the interest rate on your savings account flow from the signals it sends. When that market shakes, the world feels it. And right now, that is what the war in Iran is causing.

The US Treasury market is under stress and no one will be spared the pain.

The inflation fuse

Wars in the Middle East have a habit of producing oil shocks. According to Dr Fatih Birol, head of the International Energy Agency, this one has produced the biggest of them all – bigger than the shocks of the 1970s as well as Russia’s war on Ukraine.

One month on from the start of the war, oil prices have soared around 60 per cent for Brent crude.

Iran controls the Strait of Hormuz, through which roughly a fifth of the world’s oil passes, some 80 per cent of it bound for Asia. When conflict flares near those waters – or even when it threatens to do so – energy traders reach for the panic button.

Oil and gas prices as well as shipping costs surge, which triggers price increases for petrol, diesel, petrochemicals, fertilisers, food, plastics, helium and sulphur, among other products.

Higher inflation soon follows, accompanied by supply chain disruptions, currency shocks and economic slowdowns.

The inflationary impact is already being felt. In the US, the average price of petrol has risen roughly 33 per cent in a single month, crossing US$4 a gallon – US$1 higher than before the war. Petrol and electricity prices in Asia, including Singapore, are also shooting up.

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Food prices will follow, driven by imminent shortages; the global price of urea – the main fertiliser used by farmers everywhere – has spiked around 30 per cent since Feb 28, threatening crop yields and food harvests.

These price increases have a huge impact on Treasury bonds because bonds are allergic to inflation. A bond promises a fixed stream of payments in the future. If those payments are eroded by rising prices, the bond is worth less. Investors demand higher yields – higher interest rates – to compensate.

This is what has happened. When the war began on Feb 28, the 10-year Treasury yield stood at around 3.9 per cent; it has since climbed to an eight-month high of 4.4 per cent as at Mar 30, while the two-year yield surged from 3.35 per cent to 3.9 per cent, despite the fact that the US Federal Reserve has not raised interest rates.

These movements punish every holder of US government debt and people exposed to whatever is priced off it.

Higher long-term yields translate into higher fixed-rate mortgage rates. Increases in two-year yields mean higher interest rates on flexible-rate mortgages like most in Singapore, credit card debt and short-term corporate loans.

Central banks, which spent the past few years painstakingly engineering a soft landing from the post-pandemic inflation surge, now face a rude interruption. Rate cuts that markets had pencilled in for 2026 look increasingly far-fetched.

Some central banks are already moving in the opposite direction.

Citing the war’s inflationary impact, Australia’s Reserve Bank raised its benchmark rate on Mar 17 to 4.1 per cent – the highest since April 2025. The European Central Bank postponed its planned rate reductions on Mar 19.

In the US, markets are now pricing in a 52 per cent probability of a Fed rate hike later this year, based on Fed Funds futures prices – a sharp contrast to the two cuts that had been expected at the start of 2026.

Former governor of the Bank of Japan Haruhiko Kuroda recently told the Asahi newspaper that the war would “only accelerate interest rate hikes” instead of a pause in monetary normalisation. The policy rate could double to 1.5 per cent by 2027, he said.

OCBC economists wrote earlier in March that most central banks in South-east Asia are “at or near the end of the monetary policy easing cycle”, even though inflation had been benign at the start of the year.

Most analysts expect the Monetary Authority of Singapore to tighten its monetary policy in April, having already acknowledged inflation risks.

In short, the world’s central banks are being dragged backwards by the war, tightening the screws on already strained economies precisely when many can least afford it.

Gulf’s shattered piggy bank

But the war makes the story structurally more dangerous than just inflation-induced monetary tightening.

For decades, a quiet recycling operation has kept the US borrowing machine humming. Gulf states – Saudi Arabia, the United Arab Emirates, Kuwait and Qatar – have been selling their oil and gas in US dollars, accumulating vast dollar surpluses, and reinvesting much of that wealth in US assets, especially Treasuries.

This is the so-called petrodollar system, and it has worked to Washington’s great advantage; Gulf money has helped keep US borrowing costs artificially low for a long time.

A war that damages Gulf energy infrastructure, as it has already done, disrupts this cycle in two ways. First, when oil facilities are struck – refineries, pipelines, export terminals – the Gulf countries earn fewer dollars, which means fewer dollars recycled into Treasuries.

Second, even the dollars these states do accumulate face a competing claim: their own reconstruction.

Governments that need to rebuild damaged ports, oil processing facilities or liquefied natural gas terminals are not going to park that capital in Treasuries. They will spend it at home, and the bills could run into the hundreds of billions of dollars by the time the war is over.

As big buyers like the Gulf states stay away from the market, US Treasury yields face upward pressure.

But there is also a subtler and more insidious dynamic at work: fear. Financial markets run on confidence. Right now, uncertainty is extreme.

Nobody can say whether the conflict will stay contained or intensify – for instance, what a possible US ground invasion will lead to, whether and how much more Gulf energy infrastructure will be destroyed, whether Iran will attack more tankers in the Strait of Hormuz or whether the Houthis in Yemen will blockade the Red Sea, cutting off Saudi Arabia’s pipeline oil from the markets.

In the face of such risks – all of which are plausible – investors retreat to safety. The traditional safety trade is to buy Treasuries. But this crisis, unusually, makes Treasuries part of the problem rather than part of the solution because the risks threaten to send Treasury yields even higher.

Unusual strains are already showing up in the Treasury market. On Mar 24, a US$69 billion auction of two-year notes went badly, pushing yields up 10 basis points in a single day.

The lack of liquidity in Treasuries was so severe that some big Wall Street banks turned off the screens they use to automatically quote prices, forcing buyers to revert to slower manual human-to-human trading.

It was a replay of what happened during the bond market turmoil in April 2025 after US President Donald Trump announced his “Liberation Day” tariffs, and which the bond market forced him to backtrack.

Treasuries are supposed to set the so-called “risk-free rate” – the return you can get for lending money to the world’s most creditworthy borrower. When the risk-free rate rises sharply, everything else must reprice.

Stock valuations, which are essentially bets on future corporate profits discounted at today’s interest rates, come under pressure.

Growth stocks, whose earnings lie furthest in the future, suffer the most. Corporate bonds, which already carry higher yields than Treasuries, see their spreads widen as investors demand more compensation for credit risk in an environment of slowing growth and rising costs.

The contagion from a troubled Treasury market spreads throughout the global financial system.

How this ends – or doesn’t

None of this means collapse is inevitable. Markets have absorbed Middle Eastern and other shocks before. The Fed has demonstrated, for instance during the pandemic in 2020, a willingness to step in as buyer of last resort in Treasury markets if dysfunction becomes severe.

Other foreign buyers – Japan, Britain, China, other parts of Asia – might partly fill the gap left by retreating Gulf investors. Oil prices, however high they spike, have historically come back down once the panic fades.

But those reassurances depend on the war remaining contained, on infrastructure damage proving temporary, and on investor confidence holding. Each of those conditions is uncertain.

Moreover, the US Treasury market entered this crisis in an already fragile state. Many countries have been diversifying some of their reserves away from the US dollar in recent years.

Since 2015, the share of foreign-held US securities that were Treasuries declined from 35 per cent to 23 per cent. Decades of US deficit spending have led to a debt level of more than US$39 trillion, creating a financing need that demands constant and eager foreign participation.

A prolonged, escalating war in Iran does not need to trigger a financial catastrophe to do serious damage. It only needs to make the world’s lenders a little more reluctant, a little more cautious, a little less willing to fund America at the rates it has come to expect.

In a market this large, even a small change in marginal demand is enough to move yields meaningfully.

The tremor in the US Treasury market has already begun. The course of the war will decide whether it stays a tremor or becomes an earthquake. THE STRAITS TIMES