Amid escalating Middle East geopolitical conflict and surging oil prices, the U.S. interest rate market is displaying unusual pricing for potential rate hikes. Last Friday, market pricing briefly indicated a more than 50% probability of a Federal Reserve rate hike by December this year.
A recent report from the interest rate strategy team at Morgan Stanley suggests that while the U.S. Treasury market appears to be pricing in a Fed rate hike by year-end, it is actually preemptively pricing in an extremely large-scale "fiscal stimulus" expected from the U.S. government. The team believes that in the post-pandemic era, investor expectations regarding policy responses to crises have fundamentally shifted. Instead of waiting for central banks to cut rates to rescue markets, investors are now betting on governments directly using fiscal measures to fill economic gaps. This paradigm shift is reshaping the safe-haven logic of U.S. Treasuries and the broader macro trading framework.
What exactly is the market signaling with this unusual pricing for rate hikes? As the Iran conflict entered its third week, a rare scene unfolded in the U.S. interest rate market: last Friday, market pricing briefly implied a probability exceeding 50% for a December rate hike. Compared to the Fed's March dot plot and the New York Fed's surveys of primary dealers and market participants, the market-implied path for the federal funds rate is significantly higher at all time horizons. This sharp divergence has left many investors puzzled.
To explain this significant divergence, Morgan Stanley's interest rate strategy team conducted a sophisticated probability analysis. They compared four macroeconomic scenarios predicted by their economists—Baseline (55% probability), Upside Demand (10%), Upside Productivity (15%), and Mild Recession (20%)—against current market pricing. The results showed that the probability-weighted terminal federal funds rate from the economists' scenarios was 3.24%, while market pricing implied a much higher 3.63%. To align with this market pricing, Morgan Stanley found it necessary to make extreme adjustments to the probabilities: dramatically increasing the "Upside Demand" scenario probability from 10% to 41%, raising the "Upside Productivity" scenario to 59%, while reducing the probabilities for both the Baseline and Mild Recession scenarios to zero. This implies the market is almost entirely excluding the possibility of economic weakness and is heavily betting on a strong pulse of demand growth.
Against the backdrop of energy shocks and soaring oil prices, such pricing seems irrational—unless the market is confident in the existence of a significant external force powerful enough to offset the energy cost burden. Morgan Stanley's answer is: unexpectedly large fiscal stimulus.
The report states that the U.S. interest rate market is now focusing on an actively intervening government, rather than an actively intervening central bank. The team points out that the pandemic and its aftermath have fundamentally altered investor perceptions of crisis policy responses. Pre-pandemic, the market's reflex was clear: growth crisis → central bank rate cuts → buy government bonds. Now, however, investors seem to have developed a new conviction—when facing a growth crisis, the first responder is no longer the central bank, but the government. This is because central banks are preoccupied with tackling persistent inflation waves, potentially leading to responses that are too slow or too late. In the U.S., investors might be looking past the demand-destroying effects of high oil prices and instead pricing in the "gap-filling" effect of fiscal stimulus. If fiscal stimulus compensates for the demand gap caused by high oil prices, then energy inflation would exist in isolation—demand remains robust while inflation stays high. This scenario would precisely force the Fed to abandon accommodative policies and potentially turn hawkish.
Several clues support this shift in macro expectations. The unusual movement in inflation expectations is notable. The 1-year forward, 1-year (1y1y) CPI swap rate, which Morgan Stanley tracks, has risen since the conflict began, contrary to its decline following the "Liberation Day" event on April 2 last year. As long as the positive correlation between oil prices and the 1y1y CPI swap remains unbroken, it suggests oil prices haven't yet reached a level high enough to destroy demand. Conversely, it might indicate the market expects government intervention before demand is significantly damaged. Precedents exist in Europe, such as the Spanish government proposing a €5 billion energy relief package including VAT reductions and subsidies, and the Portuguese government approving legislation allowing temporary electricity price caps during an energy crisis.
However, Morgan Stanley emphasizes that the fiscal stimulus needed to explain current U.S. Treasury pricing must far exceed mere military supplemental appropriations related to the Iran conflict. Currently, the Pentagon has received approximately $840 billion in base defense appropriations for FY26, plus about $150 billion in supplemental funding via the OBBBA. Morgan Stanley believes the Treasury will likely finance conflict-related supplemental appropriations by issuing Treasury bills (T-bills). Regarding reported additional supplemental appropriations of around $200 billion, Morgan Stanley's public policy strategists see a difficult path to approval. Pure military funding alone is insufficient to generate the growth impulse that would force a Fed policy shift. If the market is truly pricing a hawkish turn, it must be anticipating a fiscal package directly targeting the private sectors most impacted by rising energy costs. Notably, Morgan Stanley's public policy strategists further indicate that political maneuvering around supplemental appropriations—and any targeted fiscal policies linked to economic conditions—could evolve as the conflict persists. The longer the conflict lasts, the higher the probability of supplemental appropriations being approved, potentially carrying additional economic stimulus measures along with them.
Other market signals also corroborate expectations of fiscal expansion. U.S. equity resilience has exceeded expectations—the S&P 500 is down only about 6% since February 27, significantly better than the 13% decline during the escalation of the Russia-Ukraine conflict. U.S. Treasuries have weakened notably relative to SOFR swaps—the spread between the 30-year Treasury and SOFR has narrowed by 10 basis points since February 27. Even before new capital rules, 2-year Treasuries began underperforming SOFR swaps, a classic signal of market concern over increasing Treasury supply. Simultaneously, Treasuries have failed to provide the expected hedging protection during risk-asset sell-offs. This is partly due to the Fed not being dovish enough, and partly because the market is pricing in increased Treasury supply resulting from fiscal expansion.
Compounding the challenges for U.S. Treasuries, beyond internal expectations of massive supply from fiscal expansion, tangible external selling pressure is also emerging: Middle Eastern nations may be liquidating holdings on a large scale. The report discloses that Kuwait, Saudi Arabia, and the UAE collectively hold a substantial $313.5 billion in U.S. Treasuries as of January 2026, with holdings from all three countries trending upward since 2022. However, custodian data from the New York Fed raises a stark warning: since February 25 (the conflict's outbreak), foreign monetary authorities have been net sellers of approximately $58 billion in U.S. Treasuries. The destination of these funds is even more concerning. During the same period, the New York Fed's reverse repo facility for foreign monetary authorities (FIMA RRP) increased by only $3 billion. This suggests the proceeds from the sales are not flowing back into the "safe harbor" of the Fed's system, and the funds are likely truly exiting the U.S. Treasury market. Given the conflict context, it is reasonable for the market to speculate that Middle Eastern countries are liquidating Treasuries to raise funds for defense and potential reconstruction costs.
Facing this complex situation, Morgan Stanley advises investors to maintain a neutral stance on the duration and curve direction of U.S. Treasuries, awaiting further clarity on the impact of the Iran conflict on monetary and fiscal policy. From a trading perspective, Morgan Stanley maintains a long position on the spread between the 2-year Treasury (maturing September 2027) and SOFR swaps, initiated at -14.8 basis points, targeting -14 basis points, with a trailing stop at -18.5 basis points.
Beyond specific trading levels, the report highlights a potentially underestimated paradigm shift worthy of investor consideration: in the post-pandemic world, as markets begin to view fiscal stimulus, rather than central bank rate cuts, as the primary crisis response tool, the safe-haven attributes of government bonds, the pricing logic for inflation expectations, and indeed the entire macro trading framework, require recalibration. Superficially, the market is pricing in "rate hikes"; in reality, it is pricing in "QE"—but this time, the protagonist is not the Federal Reserve, but the U.S. government.