A 20-Basis-Point Rate Hike? Iran War Rewrites Fed Monetary Policy, Global Bond Markets Under Pressure

TradingKey - Following the oil-price-driven inflationary shock triggered by the war in Iran, widespread market expectations for Federal Reserve rate cuts have been completely dashed, and bond traders are now scrambling to adjust their strategies.

Last week, warnings from major central banks regarding inflation sent short-term yields surging, leading traders to completely erase expectations for further Fed easing through 2026, as strategies betting on rate cuts were broadly hammered.

By last Friday, as global benchmark crude oil prices remained at their highest levels since 2022, market sentiment underwent a dramatic reversal—at one point, traders even priced in a 50% probability of a Fed rate hike by the end of October.

On Monday, traders further ramped up bets on Fed rate hikes, pricing in a 20-basis-point increase by the end of the year.

Data shows that market expectations for Fed action this year have shifted from a 25-basis-point cut a week ago and an 8-basis-point hike last Friday to a 20-basis-point hike currently.

John Briggs, Head of US Rates Strategy at Natixis North America, stated: "As long as the war in the Middle East is in escalation mode rather than de-escalation mode, market concerns over inflation will outweigh concerns over growth, which is reasonable given the history of recent supply shocks—now is a good time to sit on the sidelines, let the dust settle, and then reassess."

Escalating Geopolitical Conflict Roils Global Bond Markets

The conflict in the Middle East is triggering severe volatility in global bond markets. Driven by soaring oil prices that have pushed up inflation expectations, global bond market value evaporated by more than $2.5 trillion in March, marking the largest monthly decline since September 2022 as the specter of stagflation looms over the market.

According to data compiled by Bloomberg, as of March 23, the total market value of global government, corporate, and securitized debt has fallen from nearly $77 trillion at the end of February to $74.4 trillion, a monthly decline of 3.1%. This trend is notably anomalous, breaking the convention of capital flowing into bonds for safety during periods of geopolitical turmoil.

The two-year U.S. Treasury yield returned above 3.9%, touching its highest level since last July. In July of last year, the front end of the Treasury yield curve plunged sharply due to weak employment data, initiating a steady seven-month downward trend; however, these losses have been entirely erased since the attack on Iran.

Seth Golden, chief market strategist at Finom Group, noted in a post that the two-year Treasury yield has decoupled from the federal funds rate, and the federal funds futures market is increasing bets on a rate hike this year, a situation mirroring 2022.

He stated that the 2022 rate hikes did not have a significant impact on the consumer economy, which was cushioned by fiscal-driven factors at the time, specifically government transfer payments and tax legislation—a buffer that continues to persist today.

He added that Fed Chair nominee Kevin Warsh might advocate for utilizing other tools in the Federal Reserve's toolkit to address reflation risks, rather than relying solely on interest rate adjustments.

Central Bank Caught in Rate Hike Dilemma

The bond sell-off is accelerating its spread as markets rapidly digest stagflation expectations, leaving multiple central banks caught in the dilemma of being forced to raise interest rates during an economic downturn. Persistently high oil prices are compelling major central banks to reassess their monetary policy paths, and global rate hike expectations are heating up quickly.

BNP Paribas' interest rate strategy team noted in a client report last week that if energy prices remain high and the labor market stays stable, the Federal Reserve may signal a rate hike at its April policy meeting.

In the Eurozone, markets see a roughly 71% probability of a 25-basis-point hike in April, with widespread expectations that the European Central Bank is almost certain to raise rates by at least the end of June. Just this Monday, ECB Vice President Luis de Guindos also issued hawkish signals, suggesting the bank might take action to raise rates in response to the impacts of the war in Iran.

Nguyen Trinh, a senior economist at Donghua Bank in Hong Kong, pointed out that higher inflationary pressures have constrained central banks' policy maneuvering room, forcing some to raise interest rates during an economic downturn to curb inflation and prevent domestic currency depreciation.

Kathryn Rooney Vera, Chief Market Strategist at StoneX Group, stated that the market is beginning to price in the impending stagflation shock, and the longer the war drags on, the higher oil prices may rise.

At the same time, the global economy will face its first "comprehensive check-up" this week since the outbreak of the war in the Middle East, as multiple countries release a flurry of preliminary March PMI data. This data set is seen as a key indicator of the war's impact on the global economy and will provide the market with an important window to observe changes in corporate activity and economic confidence.

On Tuesday, major global economies including Australia, Japan, India, the Eurozone, the UK, and the US will simultaneously release preliminary PMI data, forming a "Global PMI Day."

Industry experts generally expect that, due to surging energy prices and supply chain disruptions, manufacturing and services PMI data in many countries may weaken in tandem, with the pressure on manufacturing likely to be particularly significant. Analysts pointed out that this will be the first time in the three weeks since the war began that the market has received quantitative evidence to gauge the cumulative impact on the global economy.

Chris Williamson, Chief Business Economist at S&P Global Market Intelligence, emphasized that while current market focus is concentrated on the inflationary push from the war, central banks also need to be wary of the recessionary risks it brings. Therefore, signals of weak demand and declining confidence reflected in the PMI data will also be a key focus for policymakers.