Is a Rate Hike Really Coming? A Shift Unseen in Three Years: US Debt "Declares War" on Fed Rate Ceiling

Amid the inflation shock driven by oil prices triggered by the Iran war, the market’s previous expectations of Fed rate cuts have been dashed, and bond traders are rushing to develop new strategies.

Last week, as warnings from major central banks about inflation caused short-term yields to soar, traders completely eliminated expectations of further easing by the Fed in 2026, and bets on rate cuts suffered a comprehensive blow. By last Friday, with global benchmark crude oil prices remaining at their highest levels since 2022, market sentiment reversed sharply—traders even once believed there was a 50% chance the Fed would raise rates by the end of October.

John Briggs, Head of US Interest Rate Strategy at Natixis North America, said, “As long as the Middle East conflict remains escalatory rather than de-escalatory, market concerns about inflation will outweigh concerns about growth. Considering recent historical supply shocks, this concern is reasonable—now is a good time to step back, wait for the dust to settle, and reassess.”

To determine the next move, one must try to predict the trajectory of the war and oil prices, and their impact on economic growth and inflation. Given that there are almost no signs of easing in US-Iran hostilities, and US officials have indicated that the White House is dispatching thousands of Marines to the Middle East, this is undoubtedly a challenging task.

Meanwhile, last week, the two-year US Treasury yield broke through 3.75%—pushing through the upper limit of the current Fed target range for the federal funds rate. As of last Friday’s close, the yield on the two-year note was about 3.89%—the highest since July last year.

Since 2023 (when the Fed was still raising rates), this yield, which best reflects market expectations of Fed interest rates, has never been so significantly above the Fed’s upper rate limit. This undoubtedly indicates that the interest rate balance in the bond market is starting to tilt toward rate hikes.

In other maturities, the five-year US Treasury yield also broke above 4% last Friday for the first time since July, while the 10-year yield reached 4.39%, the highest since August. As traders increasingly believe the Fed may hike rates again, the US dollar has nearly strengthened across all major non-US currencies.

Market rate cut expectations shattered

John Briggs, Head of US Interest Rate Strategy at France’s Natixis, is among the strategists most caught off guard by this ongoing bond sell-off, which is pushing US Treasury yields to multi-month highs.

Previously, Briggs believed that prolonged conflict would drag down the economy and that the possibility of Fed rate cuts still existed. But now, he no longer holds that “luxury,” having closed out several rate cut bets he had established earlier this month.

One such bet was on the widening of the yield spread between the 10-year and 2-year Treasuries, known as a “steepening yield curve” trade. Over the past few days, as inflation expectations rose along with oil prices, short-term yields surged relative to long-term yields, nearly ending this trade entirely. Even a previously profitable trade—betting on rising inflation expectations—was closed to lock in gains.

Meanwhile, TD Securities also exited a trade last week betting on the widening of the UK 2-year and 10-year government bond yield spread after triggering stop-losses.

Traders had previously flocked to bets that the Fed would cut rates this year to support the labor market, and early 2026 bets on “yield curve steepening.” But even before the outbreak of Middle East hostilities, this strategy had begun to unravel as officials signaled reluctance to ease further amid stubborn inflation.

Geopolitical conflicts and rising oil prices have undoubtedly accelerated this reversal. But the main catalyst that shattered market expectations of rate cuts last Thursday actually appeared the day before—when Fed Chair Jerome Powell stated that officials need to see progress on inflation before further rate cuts, and given the Middle East war, clarity is lacking.

For some investors, this uncertainty is a reason to step back and observe how long the oil supply disruptions in the Middle East will last.

Steven Williams, Head of Fixed Income for Europe, Middle East, and Africa at Amova, said Powell’s comments “reflect many of the views circulating in the market.” “Given the current peak in uncertainty, we are trying to hedge our risk exposure. We need to keep some powder dry and act once the situation becomes clearer.”

First economic data will reveal the impact of the Middle East conflict

It’s worth noting that this week, the first economic data reflecting the shockwave from the Middle East war will be released—the first collective “health check” of the global economy since the outbreak of the conflict, through business surveys from the US to the Eurozone.

Tuesday will be a new “Global PMI release day,” with preliminary March PMI data from countries including Australia, Japan, India, the Eurozone, the UK, and the US. According to median forecasts from economists surveyed by media, PMI data from multiple countries are likely to decline compared to previous figures.

Their forecasts point to a “synchronous weakening” of manufacturing and services sectors across nations. These results will provide an initial perspective on the cumulative economic damage three weeks after the US and Israel’s attacks on Iran.

Due to disruptions in regional shipping and production causing energy prices to soar, threatening global consumer prices, central banks in several countries have taken a series of hawkish measures in recent days. The Bank of England has shelved easing plans, the Eurozone counterparts have shifted toward tightening, and Australian policymakers have directly raised interest rates. As mentioned earlier, after the Fed signaled that rate cuts are still a distant prospect, investors have also erased bets on any such moves by the Fed this year.

“The primary concern now is the impact of the war on inflation,” said Chris Williamson, Chief Business Economist at S&P Global Market Intelligence, which compiles the index. “But central banks also need to consider the recession risks brought by the war, which means they will also look for signs of weakened demand and business confidence in the PMI data.”

Germany, Europe’s largest economy, will release its highly anticipated Ifo Business Climate Index on Tuesday, expected to fall to a 13-month low. More survey data from France and Italy will be released later this week.

The OECD, headquartered in Paris, will also publish forecasts this week, reflecting the changing global economic outlook—its first such comprehensive assessment since the Middle East war erupted. This may serve as a preview for the IMF’s more comprehensive forecasts due in mid-April.

In the coming week, investors will also focus on comments from Fed officials after last week’s hold on interest rates, as they monitor the economic fallout from the Iran war.

On Tuesday, Fed Governor Bostic will speak on the economic outlook. Other speakers include the only dissenting voter from the March policy meeting, Mester, along with Vice Chair Jefferson, San Francisco Fed President Daly, and Philadelphia Fed President Posen, all scheduled to speak later this week.

Despite the sharp rise in US Treasury yields, many traders are currently facing another threat—the ongoing high energy costs may shift the narrative from “inflation anxiety” to concerns about “economic growth.”

George Catrambone, Head of Fixed Income at DWS Americas, envisions exactly this scenario. He said, “Oil prices and Treasury yields can’t keep rising in tandem forever. There will always be a downside risk that needs to start pricing in the economy, earnings multiples, and risk assets.”