As market optimism grows over a potential peace agreement between the United States and Iran, the U.S. Treasury market has recently returned to a state of calm. Volatility indicators have fallen to their lowest levels of the year, nearly erasing all the market panic triggered earlier by the Middle East conflict and surging oil prices. At the same time, the 30-year U.S. Treasury yield has notably pulled back from near 19-year highs. With the market recently beginning to price in the possibility of a peace deal between the U.S. and Iran, Treasury yields have gradually declined, and market sentiment has clearly stabilized.
However, Morgan Stanley’s strategy team believes that the market’s current expectation of “sustained calm” may be underestimating future potential risks. Strategists, including Shaun Zhou, stated in a recent report that factors such as renewed shocks to the energy market or an escalation in geopolitical conflicts could quickly reignite long-term interest rate volatility. The report noted that the market has formed a distinctly asymmetric situation, where only a relatively small macro catalyst could lead to a significant repricing of long-term rate uncertainty.
Morgan Stanley explicitly warns that the current macro environment remains “fragile,” and that many of the factors currently suppressing market volatility could simultaneously diminish in the future. The extremely low implied volatility suggests the market may be significantly underpricing risk.
Beyond the derivatives market, bullish sentiment has recently re-emerged in the cash Treasury market. According to the latest J.P. Morgan client survey, for the week ending May 26, net long positioning among investors rose to a one-month high, with long positions increasing by 5 percentage points and short positions decreasing by 2 percentage points.
Goldman Sachs stated that in the first month following the outbreak of the U.S.-Iran conflict, a significant strengthening of the U.S. dollar prompted some foreign official institutions to reduce their holdings of U.S. Treasuries to support their local currencies and alleviate capital outflow pressures. Goldman Sachs strategist Isabella Rosenberg noted in a report that the dollar exchange rate is one of the most important factors influencing foreign official institutions’ demand for U.S. Treasuries. Data shows that in March of this year, holdings of U.S. Treasuries by foreign official institutions declined from historical highs. Concurrently, the Bloomberg Dollar Spot Index rose by 2.4%, marking its largest monthly gain since July of the previous year. Rosenberg stated that this change is likely related to efforts by some countries to stabilize their local currencies against the backdrop of the Middle East conflict. As the war heightened global risk aversion, some emerging economies reliant on energy imports faced significant capital outflow pressures, forcing central banks to tap into dollar reserves and sell some U.S. Treasuries to support their currencies.
However, Goldman Sachs believes this phenomenon is more likely temporary and does not signify a structural shift in global demand for U.S. Treasuries. Rosenberg commented that central banks stepping in to stabilize exchange rates actually illustrates that these countries still wish to maintain their ties to the dollar system and hold U.S. Treasuries for the long term. Goldman Sachs further pointed out that if the Middle East conflict ends in the future, the dollar could revert to its previous weakening trend, which would once again support foreign official institutions in increasing their holdings of U.S. Treasuries.
