Bond traders, fearful of a further escalation in the Iran conflict, are seeking protection against the worst-case war outcomes that could compel the Federal Reserve to raise interest rates in the coming weeks.

In the options market that tracks Fed policy, demand has emerged for bets tied to the Secured Overnight Financing Rate (SOFR), indicating traders believe the Fed could hike rates as soon as two weeks from now. These trades would pay off if the bond market significantly increases bets on a rate hike before the Fed's policy meeting on April 29.

This升温 in hedging against emergency rate hike risk marks a sharp reversal in the market—just one month ago, investors were anticipating up to three 25-basis-point rate cuts by the end of this year. Since the war began on February 28, traders in the swap market have priced in roughly a 50% probability of a rate hike by December, exposing short-term Treasuries to the risk of further repricing.

According to Jeff Schuh, head of rates trading at Constitution Capital, while these latest bets do not reflect the market's baseline forecast, they do indicate growing investor concern that rapidly rising inflation could jeopardize the long positions in U.S. Treasuries built up in recent months.

As the Iran conflict pushes oil prices higher, traders worried about resurgent inflation have been caught off guard, leading them to unwind a significant number of long positions in U.S. Treasury futures. Schuh noted that the sell-off in SOFR futures and the broad rise across the U.S. Treasury yield curve have taken large funds by surprise. He pointed out that this type of trade "makes blow-up risk look skewed to the downside 90% of the time, acting as a cheap band-aid for funds seeking to manage interest rate risk."

Currently, interest rate swaps only reflect a 3-basis-point hike expectation for the April 29 policy meeting, implying just a 12% probability of a 0.25-percentage-point rate increase.