US credit markets flash warning signs as Iran war risks deepen

A prolonged conflict in the Middle East is beginning to ripple through US short-term credit markets, with early signs of strain emerging in key funding channels.

Short-term credit spreads have widened in recent weeks, reflecting growing investor unease about a drawn-out war and a broader shift toward risk aversion.

Analysts say the changes, while still modest, could signal rising liquidity risks if geopolitical tensions persist.

Uncertainty has intensified as Donald Trump escalated pressure on Iran to reopen the Strait of Hormuz, warning that "a whole civilization will die tonight" without a last-minute agreement.

Commercial paper market under pressure

Analysts are closely monitoring the roughly $1.5 trillion US commercial paper (CP) market, a critical short-term funding source for corporations and banks and a key barometer of credit conditions.

The market initially absorbed the geopolitical shock, but concerns have grown as the conflict continues.

"Credit generally has widened across the entire curve and pretty much broadly across industries," said Jan Nevruzi, US rates strategist at TD Securities in New York, in a Reuters report.

"The entire curve just got priced higher. So you have to pay a little bit more for funding."

Federal Reserve data shows that the spread between 30-day AA-rated non-financial CP and the one-month Secured Overnight Funding Rate (SOFR) has widened to 6 basis points, up from zero before the conflict began.

This spread reflects the premium investors demand for unsecured corporate lending over Treasury-backed funding.

Its widening suggests that borrowing costs are rising and credit conditions are tightening.

Lower-rated borrowers are seeing sharper increases. The spread for A2/P2 non-financial issuers has jumped to 44 basis points from 17 basis points before the war.

"It's costing (commercial paper) issuers a little bit more to fund their books," said Teresa Ho, head of US short-duration strategy at J.P. Morgan in Boston.

On the demand side, investors are becoming more cautious. Ho noted that CP buyers are holding back amid uncertainty, as "we don't know how liquidity is going to look over the next few weeks."

Prime money market funds, major buyers of commercial paper, have also seen fluctuations.

Their assets fell 2% to $1.246 trillion in the week ending April 1, suggesting some investors may be allowing holdings to mature rather than reinvesting.

Lower-quality credit shows early cracks

Market participants are paying close attention to lower-rated segments of the CP market, which are typically the first to weaken during periods of stress.

The spread between A2/P2 and top-rated A1/P1 issuers has widened to 38 basis points, up from 20 basis points before the conflict.

While still far below crisis levels seen during the COVID-19 pandemic, analysts say the move reflects a mild risk-off environment.

In periods of heightened uncertainty, money market funds tend to pull back from lower-quality issuers, demanding higher yields and widening spreads further.

Bank funding costs also edge higher

Signs of strain are also emerging in the $2 trillion US bank floating rate note (FRN) market, an often-overlooked segment that sits between short-term funding and longer-term corporate debt.

According to JP Morgan, the spread on six-month bank FRNs over overnight SOFR widened by about 13 basis points to 33 basis points in March.

FRNs are a key source of unsecured funding for major US banks, and rising spreads are widely seen as an indicator of tightening financial conditions.

"The general corporate financing story is all about people becoming more cautious about counterparty credit and credit exposures," said Joseph Abate, head of rates strategy at SMBC Nikko Securities in New York.

Cautious tone as uncertainty persists

While the current moves in credit markets remain contained, analysts warn that continued geopolitical tensions could amplify these pressures.

With funding costs rising and investors turning more selective, the early signs of stress in short-term credit markets may become more pronounced if the conflict drags on, potentially tightening liquidity conditions across the broader financial system.

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