The opinions expressed here are those of the author, a columnist for Reuters

By Jamie McGeever

ORLANDO, Florida, March 2 (Reuters) - U.S. Treasuries just clocked their best month in a year. But with war suddenly raging in the Middle East, investors must decide whether safe-haven demand will accelerate the bond market rally or if an inflationary surge in oil prices will send it screeching into reverse.

The joint U.S.-Israeli attack on Iran on Saturday, in which Supreme Leader Ayatollah Ali Khamenei was killed, marked a dramatic escalation in regional tensions. In recent weeks, the simmering conflict had already helped lift Brent crude above $70 a barrel, while also spurring investor appetite for Treasuries and pushing the 10-year yield below 4%.

Both of these moves accelerated sharply in early trading on Monday.

Oil soared as much as 14%, with Brent smashing through $80/bbl, on fears that supply from the world's most important producing region will be disrupted. And the 10-year Treasury yield tumbled toward 3.90%, its lowest level since April.

That buying frenzy later cooled, especially at the short end of the Treasuries curve, where the 2-year yield flipped to trade 6 basis points higher.

The dilemma for bond investors is this: buy Treasuries to hedge against a slump in risk assets amid spiking geopolitical risk, or sell in anticipation of the inflation - and possible Federal Reserve policy response - coming down the pike from soaring oil prices?

In other words, which half of the "stagflation" dynamic will carry the day?

FLIGHT TO SAFETY

Investors' initial instinct was to run for cover. With stocks around the world tumbling, the allure of Treasuries and other highly rated government bonds appeared overpowering. Most benchmark Asian and European equity indexes fell between 1% and 2% on Monday, and European yields initially fell.

That's understandable, given the potentially crushing impact of spiking oil prices on economic growth.

Jordan Rochester at Mizuho estimates that a sustained $10/barrel rise knocks roughly 10-20 basis points off growth over the following year. Oil is already up $20/bbl in the last six weeks, and $100/bbl could soon be in the cards. If crude were to rise well above that threshold and stay there, the global economy would take a major hit.

Set this against the backdrop of deepening doom around the potentially destructive impact of artificial intelligence on white-collar jobs in the coming years, and the "bull" case for Treasuries looks strong.

OIL NOW +13% YEAR-ON-YEAR

While the "risk off" trade immediately following the U.S.-Israeli strikes sparked an immediate flood of demand for Treasuries, a relentless rise in oil ultimately pushes other prices higher.

Significantly higher oil is inflationary, "just as it was when Russia invaded Ukraine," analysts at Rabobank point out.

Economists estimate that a sustained $10 rise in oil boosts annual U.S. inflation by up to 0.2 percentage point. That might not sound like a lot. But the Fed's preferred measure of annual inflation is already 3% and creeping higher – so every additional increase matters.

Mizuho's Rochester says oil in the $100-$130/bbl range for any length of time would not only take Fed rate cuts completely off the table, but probably trigger a mild rate-hiking cycle "at the very least".

Broad-based price pressures in the U.S. are already pointing higher. Producer price inflation data for January released on Friday was much hotter than expected, and the disinflationary drag from oil has now flipped to an inflationary impulse.

Last week, the year-on-year price of Brent crude turned positive. If sustained, it will be the first time since mid-2024 that oil's base effect will exert upward rather than downward pressure on annual inflation calculations.

In early January, Brent crude was nearly 30% cheaper than a year earlier. It's now 13% more expensive than it was 12 months ago. That's a significant shift in inflation models, which will be flashing red on Fed officials' radars.

With energy and motor fuel accounting for a combined weighting of more than 9% in the U.S. consumer price index, $100/bbl oil could translate into a 0.8-1.5% increase in the CPI if it's sustained and fully reflected in higher gasoline prices.

Even that could be a significant underestimate, were rising oil prices to lift housing, transport, food and other costs too.

Treasuries and oil have already retreated from their highs set early on Monday. But the conflict in the Middle East is a highly fluid situation – and it appears to be spreading – so sentiment is liable to change in the blink of an eye.

One certainty, however, is that Treasuries investors' jobs just got a whole lot harder.

(The opinions expressed here are those of Jamie McGeever, a columnist for Reuters)

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(By Jamie McGeever; Editing by Alex Richardson)

((jamie.mcgeever@thomsonreuters.com; Reuters Messaging: jamie.mcgeever.reuters.com@reuters.net/))