As the Iran conflict enters its second month, the market is transitioning from short-term inflation panic to forward-looking pricing for fiscal stimulus.
On Monday, as WTI crude oil surpassed $100 per barrel, U.S. Treasury yields unusually declined, with the 10-year yield falling by nearly 8 basis points to 4.348%.
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Market pricing has synchronized its shift. The money market has lowered the probability of a Federal Reserve rate hike in 2026 from about 35% last Friday to around 20%, and is instead repricing expectations for a moderate rate cut within the year.
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This &#34;de-coupling&#34; trend marks the market's shift from short-term inflation panic to concerns about a medium-term economic recession, and proactive positioning for the next round of fiscal stimulus.
Goldman Sachs analyst Chris Hussey pointed out that the core of the market's focus this week remains the tug-of-war between growth and inflation:
<blockquote>
<ul>
<li>On the inflation front, spiraling prices of oil, natural gas, aluminum, and their derivatives threaten to permeate globally, especially Asia;</li>
<li>On the growth front, the continued uncertainty in the Middle East, coupled with the energy price shock, is dimming the outlook for labor demand.</li>
</ul>
</blockquote>
While the short-term path may remain complex, Goldman Sachs's judgment is that bond yields will ultimately decline under various scenarios, while long-term equity volatility will rise, and the market will face &#34;economic growth panic&#34; rather than &#34;persistent inflation panic.&#34;
Morgan Stanley's Chief Interest Rate Strategist Matthew Hornbach went further, suggesting that the U.S. interest rate market may increasingly reflect an expectation that fiscal stimulus will follow the demand destruction caused by the energy shock.
<h2>Correlational De-coupling: Divergence in Bond and Oil Markets</h2>
Since the outbreak of the Iran conflict, the market's pricing logic has been quite straightforward: long energy, short everything else.
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However, cracks have appeared in the past week. Despite the surge in energy prices, long-term inflation expectations have barely budged. Measured by the five-year inflation swap, market expectations for inflation over the next five years have fallen by about 20 basis points from their January highs, retreating to levels seen during the turbulent period last April.
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Francisco Simón, Head of European Strategy at Santander Asset Management, stated:
<blockquote>
While inflation remains a concern, the potential drag on growth and confidence should begin to act as a hedge, limiting further yield increases.
</blockquote>
He added that the bond market is currently one of the clearest tools for pricing the macroeconomic impact of the conflict.
Torsten Slok, Chief Economist at Apollo, also noted that there is a significant premium embedded in the current 10-year interest rate. Under normal Federal Reserve expectations, the 10-year rate should be around 3.9%, not the current 4.4%, implying an &#34;excess premium&#34; of about 55 basis points.
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The sources of this premium might include fiscal concerns, quantitative tightening, declining foreign demand, and doubts about the Federal Reserve's independence. Slok commented:
<blockquote>
Investors need to seriously consider what these 55 basis points actually mean.
</blockquote>
Meanwhile, U.S. Treasuries have underperformed SOFR swaps since February 27th, with even 2-year Treasuries starting to lag behind SOFR swaps, suggesting the market is already pricing in the risk of increased Treasury supply.
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<h2>The Bond Market's True Pricing: Fiscal Stimulus, Not Monetary Easing</h2>
Morgan Stanley's Hornbach proposed a deeper analytical framework in his report.
He believes that the current pricing logic in the U.S. Treasury market may no longer solely reflect monetary policy paths, but rather is anticipating the government's fiscal response to an energy shock.
Historically, the COVID-19 pandemic profoundly altered investors' understanding of crisis response mechanisms.
Pre-pandemic, markets defaulted to central banks as the primary crisis response tool; now, investors seem to believe that fiscal policy has become the main force in responding to growth crises, while central bank actions are constrained by persistent inflationary pressures.
In the current context, Hornbach pointed out that if investors are indeed pricing in fiscal stimulus significant enough to force a Federal Reserve pivot, its scale must far exceed supplemental appropriations for the Iran conflict and must cover the private sector most impacted by rising energy costs.
Morgan Stanley's public policy strategists believe that the political maneuvering for supplemental appropriations is already challenging, and the extent to which additional stimulus measures can be opened up depends heavily on the duration of the conflict.
Precedents already exist. The Spanish government proposed a 5 billion euro energy price relief package, including VAT reductions and subsidies; the Portuguese government enacted legislation to allow for temporary electricity price caps in energy crisis situations.
<h2>Potential Risk of Gulf States Selling U.S. Treasuries</h2>
As expectations for fiscal stimulus rise, a potential hedging risk is emerging.
Morgan Stanley data shows that holdings by foreign official institutions in the New York Fed's custody account have decreased by approximately $58 billion since February 25th. During the same period, the FIMA Repo facility for foreign currency authorities only increased by about $3 billion, implying that the proceeds from these sales may have been repatriated rather than remaining within the dollar system.
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Kuwait, Saudi Arabia, and the UAE collectively held approximately $313 billion in U.S. Treasuries in January of this year, and their holdings have grown since 2022.
<img src="https://imageproxy.pbkrs.com/https://wpimg-wscn.awtmt.com/a9cf2f32-431f-4944-83a8-15b297b7a39d.png?x-oss-process=image/auto-orient,1/interlace,1/resize,w_1440,h_1440/quality,q_95/format,jpg" alt="" original-src="https://imageproxy.pbkrs.com/https://wpimg-wscn.awtmt.com/a9cf2f32-431f-4944-83a8-15b297b7a39d.png"/>
Against the backdrop of the ongoing conflict, there remains high uncertainty as to whether more Gulf states will reduce their U.S. Treasury holdings to cope with domestic military and economic pressures. This variable, combined with fiscal stimulus expectations, creates a dilemma for the bond market:
<blockquote>
<ul>
<li>On one hand, fiscal stimulus expectations are pushing yields down;</li>
<li>On the other hand, potential sustained selling pressure from Gulf states could push long-term yields higher, forcing the Federal Reserve to act more quickly if long-end Treasuries are involved.</li>
</ul>
</blockquote>
Hornbach admitted that how this contradiction will ultimately be resolved is unclear. However, the synchronized surge in gold, precious metals, and crypto assets recently clearly indicates that the market is actively positioning for some outcome within the scenarios described above.

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As the Iran conflict enters its second month and oil prices break $100 a barrel, U.S. Treasury yields are inversely declining, signaling a "de-coupling" of bonds and oil. Market logic is shifting from inflation fears to recession concerns and expectations of fiscal stimulus. Goldman Sachs predicts bond yields will eventually fall, while Morgan Stanley notes the market is pricing in fiscal stimulus following an energy shock

- The Iran conflict marks its second month, shifting the market focus from short-term inflation fears to prospective fiscal stimulus pricing.  
- With WTI crude oil surpassing $100 per barrel and a rare decline in U.S. Treasury yields, market expectations for a Federal Reserve interest rate hike in 2026 have dropped significantly.  
- This decoupling reflects growing concerns over a potential economic slowdown, as geopolitical uncertainties and rising energy prices continue to impact growth outlooks.

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The Most Significant Change? U.S. Treasuries "De-couple," Market Smells "Global Fiscal Stimulus"