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The cost of conflict. During the Vietnam War, “guns and butter” policy respected a simple trade off – more defence spending meant less handouts for the domestic economy. Today, however, trade-offs appear like a passé stance of excessive conservatism; if one possessed the world’s reserve currency, why not fund both guns and butter needs with debt? One needs to look no further than the US to see that this shift is already underway; President Trump’s passage of his landmark “One Big, Beautiful Bill Act” (butter) acted as no restraint on him starting a conflict in Iran (guns). There is however, one little snag – central bank independence. The inflationary consequence of war means that interest rates stay elevated, resulting in debt interest payments in the US now exceeding USD1tn a year and rising. This greatly reduces investors’ willingness to absorb sovereign debt since government bonds cannot be risk-free if the same government keeps adding to that risk with big, beautiful deficits.
A crude awakening. This makes the outcome of the US-Iran war especially consequential to the outlook on fixed income. The ongoing conflict has not only (a) pushed oil prices (and hence, inflation) higher through supply disruptions and sanctions, but also (b) increases the need for defence spending – President Trump has already unveiled an unprecedented request for a USD1.5tn defence budget for 2027 – invariably adding to federal budget vulnerabilities. Even if a resolution emerges in the near term, supply may take some time to normalise, leaving sticky inflationary pressure as higher input costs squeeze margins and increase cost pass-through to consumers. Expectations are already rising, with inflation swaps showing a sharp increase in demand for inflation protection since March. This leaves the Federal Reserve with less room to cut rates as aggressively as markets had expected earlier this year. Noteworthily, the 1y1y OIS rate, which reflects market expectations for interest rates in the future, has moved above the effective federal funds rate for the first time in four years. This suggests investors are placing less confidence in a one-directional easing cycle, and are pricing either fewer cuts, or a higher-for-longer policy path.
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