As the Iran conflict enters its second month, markets are shifting focus from short-term inflation fears to pricing in expectations for future fiscal stimulus. On Monday, while WTI crude oil surged past $100 per barrel, U.S. Treasury yields moved in the opposite direction, a rare occurrence. The yield on the 10-year Treasury note fell by nearly 8 basis points to 4.348%.
Market pricing adjusted accordingly. Money markets reduced the probability of a Federal Reserve rate hike in 2026 from approximately 35% last Friday to about 20%, instead repricing expectations for moderate rate cuts within the year. This decoupling trend signals that markets are beginning to transition from near-term inflation panic towards concerns about a mid-term economic slowdown and are positioning early for a potential new round of fiscal stimulus.
Chris Hussey, an analyst at Goldman Sachs, noted that the core market dynamic this week remains the tug-of-war between growth and inflation. On the inflation front, spiraling prices for oil, natural gas, aluminum, and related derivatives threaten to spread globally, particularly in Asia. On the growth front, persistent uncertainty in the Middle East combined with energy price shocks is clouding the outlook for labor demand. Although the short-term path may remain complex, Goldman Sachs judges that under various scenarios, bond yields will ultimately decline, long-term equity volatility will rise, and markets will then face "growth scares" rather than "persistent inflation fears."
Matthew Hornbach, Chief Interest Rate Strategist at Morgan Stanley, takes this a step further, suggesting that the U.S. interest rate market may increasingly be pricing in an expectation that fiscal stimulus will follow energy-driven demand destruction.
Since the outbreak of the Iran conflict, market pricing logic had been relatively straightforward: go long on energy and short everything else. However, cracks appeared over the past week. Despite soaring energy prices, long-term inflation expectations showed little significant upward movement. Measured by the five-year inflation swap, market expectations for inflation over the next five years have fallen by about 20 basis points from January highs, returning to levels seen during the turmoil of last April.
Francisco Simón, Head of European Strategy at Santander Asset Management, stated that while inflation remains a concern, potential drags on growth and confidence should begin to act as a hedge, limiting further rises in yields. He added that the bond market is currently one of the clearest instruments for pricing conflicting macro influences.
Torsten Slok, Chief Economist at Apollo, also pointed out that there is a noticeable premium embedded in the current 10-year yield. Driven by normal Fed expectations, the 10-year rate should be around 3.9%, not the current 4.4%, implying an "excess premium" of about 55 basis points. The source of this premium could include fiscal concerns, quantitative tightening, decreased foreign demand, and doubts about Fed independence. Slok emphasized that investors need to seriously consider what these 55 basis points truly signify.
Simultaneously, the performance of U.S. Treasuries relative to SOFR swaps has continued to weaken since February 27th, with even 2-year Treasuries beginning to underperform SOFR swaps, suggesting the market is already pricing in the risk of increased Treasury supply.
Morgan Stanley's Hornbach offers a deeper interpretive framework. He believes the current pricing logic in the U.S. Treasury market may no longer just reflect the monetary policy path but could be anticipating the government's fiscal response to the energy shock. Historical experience, particularly from the COVID-19 pandemic, has profoundly altered investor perceptions of crisis response mechanisms. Pre-pandemic, markets assumed the primary crisis-fighting tools came from central banks; now, investors seem to believe that the main force for tackling growth crises has shifted to government fiscal policy, with central bank responses constrained by persistent inflation pressures.
Regarding the current situation, Hornbach notes that if investors are indeed pricing in fiscal stimulus significant enough to force a Fed pivot, its scale would need to far exceed military supplemental appropriations related to the Iran conflict and must cover the private sectors hit hardest by rising energy costs. Morgan Stanley's public policy strategists believe the path for passing supplemental appropriations is already fraught with political challenges, and whether space for additional stimulus measures can be opened depends heavily on the conflict's duration. Precedents already exist: the Spanish government proposed a €5 billion energy price relief package including VAT reductions and subsidies, while the Portuguese government passed legislation allowing temporary electricity price caps during an energy crisis.
As expectations for fiscal stimulus heat up, a potential hedging risk is emerging. Data from Morgan Stanley shows that holdings by foreign official institutions in the New York Fed's custody account have decreased by approximately $58 billion since February 25th, while foreign monetary authorities' reverse repo accounts increased by only about $3 billion. This suggests the proceeds from these sales may have been repatriated rather than kept within the dollar system. Kuwait, Saudi Arabia, and the UAE collectively held about $313 billion in U.S. Treasuries as of January this year, and holdings from all three have increased since 2022. Against the backdrop of a prolonged conflict, whether more Gulf countries will reduce their Treasury holdings to address domestic military and economic pressures remains highly uncertain.
This variable, combined with fiscal stimulus expectations, creates a dilemma for the bond market: on one hand, fiscal stimulus expectations push yields lower; on the other, potential sustained selling pressure from Gulf countries could push long-end yields higher again, potentially forcing the Fed to act more quickly if a buyer's strike occurs in long-dated Treasuries. Hornbach admits it's currently unclear how this contradiction will ultimately resolve. However, the synchronized sharp rally in gold, precious metals, and crypto assets clearly indicates that markets are actively positioning for one of these potential outcomes.
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