Rate Hikes Imminent? Three‑Year Shift As U.S. Treasuries Challenge Fed Rate Ceiling

On March 23, bond traders revised strategies rapidly as inflationary pressure from the Iran conflict and rising oil prices undermined prior expectations of Federal Reserve rate cuts. Short‑term yields surged last week after central banks issued warnings about inflation, prompting market participants to abandon bets on further easing in 2026. By Friday, with global benchmark crude holding near its highest level since 2022, sentiment swung sharply and traders briefly assigned a roughly 50% probability to a Federal Reserve rate increase before the end of October.

John Briggs, Head of U.S. Rate Strategy at Natixis North America, observed that as long as the Middle East conflict escalates rather than de‑escalates, inflation concerns will outweigh growth worries, making a cautious, wait‑and‑see stance prudent. Forecasting the path of the conflict and oil prices—and their effects on growth and inflation—remains challenging, particularly as U.S. officials confirmed the deployment of thousands of Marines to the region.

Notably, the two‑year U.S. Treasury yield last week breached 3.75%, piercing the upper bound of the Federal Reserve’s current federal funds target range; it closed Friday at about 3.89%, the highest closing level since July. Since 2023, when the Fed was still tightening, this measure of market expectations for Fed policy has not exceeded the Fed’s upper bound by such a margin, signaling that the bond market is tilting toward the prospect of further tightening. Across other maturities, five‑year yields surpassed 4% for the first time since July, and ten‑year yields rose to 4.39%, their highest level since August. The dollar strengthened broadly as traders priced in renewed Fed tightening.

The market consensus for rate cuts has effectively collapsed. Briggs, who had previously viewed a protracted conflict as a factor that could weaken growth and preserve the possibility of easing, has closed earlier rate‑cut positions after mounting losses. Trades that anticipated a steepening of the yield curve—betting that long‑term yields would rise relative to short‑term yields—failed as short‑term yields climbed sharply with inflation expectations. Similar positions in other markets were also unwound following stop‑loss triggers.

The decisive catalyst for the collapse in cut expectations came after Federal Reserve Chair Jerome Powell stated that officials need clearer evidence of progress on inflation before considering cuts, and that the current conflict has reduced visibility. In response, some investors stepped back to assess how long oil supply disruptions might persist. Steven Williams, Head of EMEA Fixed Income at Amova, said Powell’s remarks reflected widespread market sentiment and prompted managers to hedge exposures and preserve dry powder until conditions clarify.

This week will deliver the first economic indicators that reflect the conflict’s impact, with preliminary March PMI releases across major economies from Australia and Japan to the Eurozone, the United Kingdom and the United States. Median economist forecasts suggest these PMI readings will decline from prior levels, pointing to synchronized weakness in manufacturing and services and offering an early gauge of cumulative economic damage three weeks after strikes on Iran. Rising energy costs have already prompted hawkish responses from central banks: the Bank of England shelved easing plans, the European Central Bank shifted toward tightening, and the Reserve Bank of Australia raised rates. Following the Fed’s signal that cuts are not imminent, markets have largely discounted any U.S. easing this year.

Chris Williamson, Chief Business Economist at S&P Global Market Intelligence, noted that while inflation is the immediate focus, central banks must also weigh recession risks, making PMI data crucial for assessing demand and business confidence. Germany’s Ifo business expectations survey is expected to fall to a 13‑month low, and additional surveys from France and Italy are due later in the week. The OECD will publish updated forecasts this week—its first comprehensive assessment since the conflict began—and these will precede the IMF’s broader outlook in April.

Investors will also monitor remarks from Fed officials following last week’s decision to hold rates steady; scheduled speakers include Governor Barr, Vice Chair Jefferson, San Francisco Fed President Daly and Philadelphia Fed President Pauleson. Despite the recent surge in Treasury yields, market participants remain mindful of a second risk: that persistently high energy costs could shift the narrative from inflation concerns to worries about economic growth. George Catrambone, Head of Fixed Income at DWS Americas, cautioned that oil prices and Treasury yields cannot rise in lockstep indefinitely and that markets will ultimately need to price in downside risks to earnings and growth.