By Polo Rocha

The rekindling of the Iran war has the bond market worried about inflation again, driving up borrowing costs for homebuyers and businesses alike.

The average 30-year fixed mortgage rate hit 6.58% this week, its highest level since last August, according to Freddie Mac. The yield on the 10-year U.S. Treasury yield—a key input into mortgage rates and business borrowing costs—also soared to its highest level this year and breached 4.7% in mid-afternoon trading.

The sharp rise in yields follows hostilities in the Middle East, with the resumption of U.S.-Iran attacks and the Iran-backed Houthis in Yemen also striking Saudi Arabian oil tankers.

“Barring a near-term pullback in hostilities from both the U.S. and Iran, oil prices may stay higher for longer, renewing inflation concerns and sustaining the pressure” on bond yields, wrote John Canavan, lead analyst at Oxford Economics.

The bond market is “once again beholden to geopolitical headlines and the real-time fluctuations in oil,” wrote Vail Hartman, a U.S. rates strategist at BMO Capital Markets.

Bond yields rise when investors expect inflation ahead, as investors will charge borrowers higher yields to protect against inflation eroding the interest rates that bonds pay. This year, that means bond yields are following the gyrations in oil markets.

Prices on the international Brent crude benchmark, which had settled back down to between $70 and $90 a barrel in recent weeks, topped $100 a barrel again on Thursday.

The ceasefire was a big reason why June’s inflation data was surprisingly tame, since the jump in oil prices consumers saw earlier this year cooled off. But the market is “clearly viewing the June CPI report as a one-off that is unlikely to be repeated,” Hartman wrote.

The moves come as Federal Reserve officials prepare for their July 28-29 meeting, where many analysts expect the Fed to keep short-term interest rates unchanged. But an inflation rebound makes Fed rate hikes more likely, analysts say, and bond markets are adjusting to those risks by driving up long-term interest rates.

“We maintain that the Fed is unlikely to raise rates next week,” Hartman wrote. “That being said, an elevated pace of core inflation during July and August would provide sufficient justification for a rate hike on Sept. 16.”

Stock Market Spillover

Rising bond yields can spill over into the stock market, according to Ed Yardeni, a veteran economist and president of Yardeni Research, who still expects a rally in equities this year. Yardeni anticipates the S&P 500 index will reach 8,250, up from today’s levels of 7,394, powered by a “resilient economy and strong earnings.”

But the market is likely to see some “choppiness” this summer, he wrote in a note to clients.

“The upward pressure on bond yields is another reason to expect a summer stall in the stock market,” Yardeni wrote, flagging jitters over artificial intelligence and a new round of U.S. tariffs as lingering concerns.

Higher bond yields mean companies—including tech firms tapping bond markets to fund their AI investments—could pay more to borrow money and thus weigh on earnings. But higher bond yields also mean investors can earn juicier interest rates on new bonds, making them a bit more attractive than riskier stocks.

Indeed, investors should consider adding high-quality bonds to their portfolio now that yields are higher, according to Ulrike Hoffmann-Burchardi, chief investment officer for the Americas at UBS.

She anticipates yields will drift back down in the months ahead, giving investors an opportunity to pick up higher-paying bonds in the meantime. Bond prices rise when yields fall, since a 10-year Treasury bond paying investors a 4.7% interest rate is more attractive than one that pays closer to 4.5% or even 4%.

Yields are likely to fall because the U.S. and Iran “will eventually seek a path toward a diplomatic framework as economic pressures mount,” Hoffmann-Burchardi wrote. Investors should be prepared for more hostilities, but an eventual peace deal should keep a lid on oil prices and inflation, she wrote.

“We continue to see scope for yields to drift lower over the coming quarters, and believe quality fixed income offers an attractive combination of income, diversification, and medium-term return potential,” she wrote.

Source: Investopedia