The bond market is flashing a stress signal that could spill over into stocks, according to an economist

• The bond market is showing signs it could be at risk of "funding stress," RSM said.
• The firm pointed to higher volatility & higher yields in the US Treasury market since the Iran war.
• The effects could eventually spread to areas like credit, currency, and the stock market, RSM said.

The US bond market is sending a warning to investors.

That's evident in the sharp increase in yields and volatility in Treasurys, two clear signs that the market for government debt is under stress from the war on Iran, according to the financial services firm RSM.

That distress could eventually spread to other areas of the financial system — in particular, the US stock market, Joseph Brusuelas, the firm's chief economist, wrote in a note on Wednesday.

"The Treasury market is signaling stress," Brusuelas said, adding that he believes investors were finally responding to the perceived severity of the oil price shock and its impact on US debt and inflation.

Treasury yields, the first stress sign Brusuelas mentioned, have climbed since the start of the Iran war. The yield on the benchmark 10-year US Treasury traded around 4.32% on Wednesday, up 36 basis points since before the conflict began.

Higher yields are a sign that investors are growing nervous about inflation and pricing in higher interest rates.

It's also a sign that bond investors are placing a higher risk premium on US Treasurys, due to the uncertain economic outlook and the potential for steeper deficits as the war drags on.

It could also signal future debt challenges for the US, Brusuelas said, as higher yields imply that it will be more costly for the government to borrow.

Treasury volatility, the second stress signal, has also moved notably higher. The MOVE index, which measures volatility in the Treasury market, recently climbed above its 52-week average to levels "consistent with past episodes of price instability and policy dysfunction," Brusuelas said.

"Sharp increases like those of the past several days are a reflection of increasing uncertainty. If the uncertainty does not abate in the near term it could lead to a broader funding stress that will challenge credit markets," Brusuelas said.

He pointed to six previous spikes in Treasury volatility, such as when inflation soared in 2022 and when markets were battered by President Donald Trump's tariffs early last year. Those episodes were accompanied by spill-over effects into other areas of the financial system, like credit, currencies, and stocks, Brusuelas said.

"It is why we think equity markets are and will trade off rate markets the further we move into the crisis," he said of how stocks could be impacted.

The outlook for equities has grown gloomier the longer the conflict in the Middle East has dragged on. For investors, the main concern is that higher oil prices could push inflation up, creating risks for the economy, dimming the outlook for rate cuts, and affecting vulnerable areas of the financial system, such as private credit.