The conflict in Iran has entered its fourth week since the escalation on February 28, showing no signs of abating and instead intensifying further. With the continued "substantive" blockade of the Strait of Hormuz, direct Israeli strikes on Iran's core energy facilities have amplified disruptions to global energy markets. Brent crude prices have climbed above $110 per barrel, while TTF natural gas prices surged 13% in a single day. The escalating situation and energy "crisis" have heightened financial market volatility, with gold prices dropping 15%, U.S. Treasury yields spiking to 4.4%, and increased fluctuations in U.S., A-share, and Hong Kong stock markets. U.S. bond volatility has reached its highest level since April 2025.
As the situation evolves, market expectations for the conflict's duration have shifted from an initial "quick resolution" to a "prolonged standoff." According to betting odds on Polymarket, the probability of the conflict ending in March has dropped from 78% on February 28 to just 4% by March 20. The highest probability (44%) is now assigned to a resolution between April 1 and May 15. As expectations are pushed further out, trading focus is gradually shifting from short-term sentiment shocks to longer-term secondary effects, such as liquidity-driven negative feedback on assets and the secondary inflationary and supply chain pressures from high energy costs. This may explain the sudden increase in volatility last week across gold, U.S. Treasuries, U.S. stocks, and even A/H-shares.
Rather than attempting to predict the conflict's trajectory—a largely futile exercise—we believe dissecting the differing expectations priced into various assets can more effectively help investors respond under different scenarios. Using Federal Reserve rate cut expectations as a baseline and bridge for measurement, we find that different assets reflect vastly divergent expectations regarding the Iran situation and oil price path. This disparity implies both risks and opportunities.
Currently, the market no longer anticipates further Fed rate cuts this year. For this to hold, it would require the conflict to persist into the third and fourth quarters with oil prices remaining above $100 per barrel. Using this expectation as a benchmark, we observe that: 1) Bonds reflect the most pessimistic outlook. After recent corrections, copper and gold have also quickly aligned with tighter monetary expectations. This suggests that unless the conflict extends into the extreme scenario of lasting until Q3/Q4, some risk has been priced in, potentially creating buying opportunities if tensions ease. 2) Conversely, equity markets do not appear to be fully pricing in a scenario where hostilities continue until Q3/Q4 with oil above $100. Therefore, a move toward such an extreme outcome could still pose downside risks. This conclusion aligns with last week's divergent performance across asset classes.
Under what conditions would the Fed be unable to cut rates? A conflict lasting into Q3/Q4 with oil prices sustained above $100 per barrel. Without the Iran disruption, U.S. inflation would peak at 2.8% year-on-year in Q2 before declining, allowing the Fed to proceed with 2-3 rate cuts as needed. From a financing cost and return on investment perspective, the current U.S. real rate of 1.8% versus a natural rate of approximately 1.2% implies a 60 basis point gap, corresponding to 2-3 cuts. Excluding Iran-related disruptions, we project the peak U.S. CPI at 2.8% YoY in Q2. High base effects from the second half of last year should lead to a gradual CPI decline after the Q2 peak, not preventing the Fed from restarting cuts in H2, especially after a likely smooth leadership transition in June.
An oil price of $100 acts as a critical threshold, pushing the inflation peak from 2.8% to 3.5%—matching the current federal funds rate range (3.5%-3.75%)—making near-term cuts difficult. However, after a temporary spike, inflation could still fall in H2, suggesting rate cuts would merely be delayed, not canceled. We estimate that a 10% rise in oil prices increases U.S. headline CPI by roughly 0.2-0.3 percentage points. Based on our commodities team's projected path (Brent rising to $120/bbl in Q2 before falling to $80-$90 in Q3/Q4), headline CPI YoY would peak around 4.6% in Q2, but high base effects and falling oil prices should pull CPI down to 2.8%-3.2%. Thus, Fed rate cuts in H2 remain possible.
For the Fed to be completely unable to cut rates this year, inflation would need to remain above 3.5% throughout, negating the high base effects in H2 2025. This requires oil prices to stay above $100 consistently into Q3 and Q4. This aligns with our commodities team's extreme scenario assessment: if the U.S.-Israel-Iran conflict persists through year-end, Brent could reach $150/bbl in Q2 and average around $100/bbl in H2.
Translating the bond market's expectation of no rate cuts this year into a view on the conflict implies an expectation that hostilities will last into Q3/Q4 with oil above $100—highlighting significant pessimism. Equity markets are clearly not this pessimistic, potentially due to investor base differences, slower transmission of earnings impacts, or hopes for a political compromise (TACO) driven by mid-term election pressures. The latest BofA Global Fund Manager Survey shows an average year-end oil price expectation of $76/bbl, with only 11% anticipating prices above $90. This stark expectation gap signifies both potential risk and opportunity.
What expectations are priced into different assets? U.S. Treasuries, gold, and copper reflect "no rate cuts this year," while equity markets are relatively optimistic. Using implied rate cut expectations as a metric, copper, gold, and U.S. Treasuries are the most pessimistic. CME rate expectations now price the first cut delayed until September 2027. Equities are more optimistic. Specifically, the implied number of rate cuts over the next year priced by various assets is: Fed Dot Plot (1 cut) > S&P 500 (0.6 cuts) > Nasdaq (0 cuts) > U.S. Treasuries (0.3 hikes) > Gold (0.4 hikes) ≈ Fed Funds Futures (0.4 hikes) > Copper (0.5 hikes) ≈ Dow Jones (0.5 hikes).
► Copper: Prices have incorporated expectations for a slight rate hike. Copper has declined due to tightening liquidity and concerns that high oil prices will dent demand. Since the Iran escalation, LME and Comex copper prices have fallen 10.6% and 12.4%, respectively. The copper-to-oil ratio has dropped from a January high of 219 to 103, touching its 2010 average, indicating market pricing for weaker demand. The Comex copper RSI has fallen to 33, nearing oversold territory. We calculate that the current Comex copper price ($5.35/lb) implies a 1-year rate expectation of 3.74%, above the current median Fed Funds rate of 3.625%, implying a 12 bp hike over the next year.
► Gold: The market has priced in no rate cuts this year. Since the Iran escalation, gold has fallen 15%, from $5,278/oz to below $4,500/oz, driven by a stronger dollar, reduced rate cut expectations, and tightening liquidity. The decline accelerated last week, with the RSI dropping from a late-January high of 90 to 29, entering oversold territory. The gold-to-oil ratio has fallen from 79 in early January to 40,接近 the 2010 average plus one standard deviation. We calculate the current gold price (~$4,492/oz) implies a 1-year rate expectation of 3.72%, slightly above the current median Fed Funds rate, implying a 10 bp hike. Holding other factors constant, the CME's expectation for no cuts until September 2027 corresponds to a gold price of $4,500/oz.
► U.S. Treasuries: Also pricing in no rate cuts this year. Since the conflict began on February 28, the 10-year Treasury yield has risen 44 bp to 4.38%. The drivers are: 1) Real rates为主导 (31 bp), with inflation expectations also rising (13 bp), reflecting market translation of high oil price pressures into expectations for the Fed maintaining higher rates for longer. 2) Rate expectations为主导 (27 bp), with the term premium largely flat, indicating yield volatility is concentrated around re-anchoring the rate cut path. This aligns with signals from rate futures, where the implied 1-year forward Fed Funds rate has increased 70 bp since February 28. This means the market's pre-conflict expectation for two cuts this year has been erased, with the implied first cut delayed from October 2026 (pre-FOMC) to September 2027. This relative pessimism suggests that the 4.4% long-end yield has largely priced in a stringent monetary path. Conversely, if the conflict ends within Q2, current long-end Treasuries may offer attractive entry points.
► U.S. Stocks: Valuations still incorporate some rate cut expectations, while earnings have not yet factored in sustained high oil prices. U.S. equities have been relatively resilient globally since the conflict began, partly because equity markets often lag bonds in reacting to rate cut shifts, and partly due to expectations for a potential TACO compromise. Decomposing index performance shows that while valuations have contracted significantly due to higher rates, recovering risk appetite has partially offset the drag, especially as earnings expectations for the S&P 500 and Nasdaq have been revised upwards, containing overall index declines. If the situation worsens, U.S. stocks could face a ~10% correction: valuations could give back rate cut expectations (3-4% down) and earnings would gradually incorporate high oil price impacts (estimated 6-7% down). Conversely, if the conflict ends within Q2, valuations could recover, but due to H1 oil price pressure on earnings, we modestly lower our year-end S&P 500 target from 7600-7800 to 7100-7200.
► Chinese Markets: Internal divergence exists, with liquidity-sensitive Hong Kong stocks and certain A-share growth segments reacting more strongly. For Chinese markets, Hong Kong stocks and growth-oriented A-shares like the STAR 50 are more sensitive to U.S. dollar and Treasury yield movements. Sustained high U.S. yields and a strong dollar would likely pressure HK stocks and A-share growth styles reliant on foreign liquidity. Since the Iran escalation, the more dollar liquidity-sensitive STAR 50 (-11.4%), Hang Seng Tech Index (-5.2%), and Hang Seng Index (-5.1%) have declined more, though HSTECH had already fallen prior, offering some valuation support. Other major A-share indices have shown relative resilience, with the SSE Composite and CSI 300 down 4.9% and 3.1% respectively, while the ChiNext Index gained 1.3%. Furthermore, sustained high oil prices could create a low single-digit drag on corporate earnings, particularly for sectors like chemicals and transportation.
Persistently high oil prices would also support a strong U.S. dollar. Short-term, rapid oil price increases bolster the dollar because: 1) Post-shale revolution, the U.S. is a net oil exporter, suffering less negative impact than economies like Europe and Japan; 2) Higher oil prices lift inflation expectations and suppress rate cut bets; 3) Tighter liquidity increases demand for cash. If oil stays above $100 long-term, raising global stagflation or recession risks, while the U.S. wouldn't be immune, pressures on economies like Europe and Japan would likely be greater, passively supporting dollar strength. Recall after the 2022 Russia-Ukraine conflict triggered global stagflation, the U.S. was less impacted by energy price rises than Europe/Japan, and combined with the Fed's aggressive hiking, the dollar rallied from 97 to 114.
How to position now? Go long U.S. Treasuries and gold if the conflict is unlikely to persist into H2; favor cash and dividends if concerned about prolonged conflict. The "expectation gap" for geopolitical risk priced across assets dictates subsequent trading logic, presenting both risk and opportunity. Based on the above: 1) Optimistic Scenario: The Iran situation resolves relatively quickly, oil prices moderate in H2, and a smooth leadership transition occurs in June, allowing H2 rate cut expectations to rebuild. 2) Pessimistic Scenario: The conflict drags on, oil averages $100 into Q3/Q4, the leadership transition is delayed, and Powell remains, drastically reducing the chance of 2026 rate cuts. Consequently, for trading strategy:
► If one does *not* expect the conflict to last into Q3/Q4, then current expectations priced into U.S. Treasuries and gold appear overly pessimistic, suggesting attractive "long" opportunities. Unless the situation protracts into H2, H2 rate cuts remain possible. Copper's outlook depends on demand improvement. Equity asset downside pressure would also likely ease significantly.
► Conversely, if concerned about the conflict extending into H2, U.S. equities—which currently underprice this risk—face correction pressure. A/H-shares would also be affected by high rates, especially growth styles, though HSTECH's significant prior decline offers some valuation support, and A-shares—particularly large-cap blue chips—may prove more resilient due to capital account controls and policy support.
Sector-wise, if the Iran situation worsens, markets may first adjust expectations for export-oriented sectors (fearing recession from high oil prices), followed by cyclicals (demand shock logic, then supply shock), and finally tech (high valuation pressure).
In such an environment, only U.S. dollar cash (short-dated bonds) and defensive sectors within A-shares might provide effective hedges (e.g., low-volatility dividend stocks, consumer/real estate sectors with low expectations, or previously corrected stocks with low valuations/positioning). Furthermore, based on our credit cycle framework, as we identified Q2 as the weakest phase in the current cycle, tactically adjusting portfolios to reduce uncertainty during this period is a reasonable strategy.
