The most important change? US Treasury "decoupling"—the market senses a flavor of "global fiscal stimulus."

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The Iran conflict has entered its second month, and the market is shifting from short-term inflation panic to forward-looking pricing of fiscal stimulus.

On Monday, as WTI crude oil surged past $100 per barrel, U.S. Treasury yields unusually moved in the opposite direction, with the 10-year Treasury yield falling nearly 8 basis points to 4.348%.

Market pricing is shifting in sync. The probability of a Federal Reserve rate hike in 2026, according to the money market, has been lowered from about 35% last Friday to about 20%, with moderate rate cut expectations for this year repriced.

This "decoupling" trend marks a shift in the market, from short-term inflation panic to concerns over a mid-term economic recession, and advance positioning for the next round of fiscal stimulus.

Goldman Sachs analyst Chris Hussey notes that the market’s core focus this week remains the tug-of-war between growth and inflation:

On the inflation side, oil, natural gas, aluminum, and derivatives prices are spiraling upward, threatening to spill over to global markets, especially Asia;On the growth side, continued uncertainty in the Middle East combined with energy price shocks is dimming the outlook for labor demand.

Although the short-term path may still be complex, Goldman’s judgment is that under multiple scenarios, bond yields will eventually decline, long-term stock volatility will rise, and the market will then face an "economic growth panic" rather than a "persistent inflation panic".

Morgan Stanley’s Chief Rate Strategist Matthew Hornbach goes further, suggesting that the U.S. rates market may increasingly reflect an expectation that fiscal stimulus will follow after energy-driven demand destruction.

Correlation Decoupling: Divergence Between Bond and Oil Markets

Since the Iran conflict erupted, market pricing logic has been singular: go long energy, short everything else.

However, cracks appeared in the past week. Despite soaring energy prices, long-term inflation expectations have barely moved up. Measured by 5-year inflation swaps, the market’s inflation outlook for the next 5 years has dropped about 20 basis points from the January peak, falling back to levels seen during last April’s turbulence.

Santander Asset Management's Head of European Strategy Francisco Simón said:

While inflation remains a concern, the potential drag on growth and confidence should begin to act as a hedge, limiting further yields increases.

He adds that the bond market is currently one of the clearest tools for pricing the macro impact of the conflict.

Apollo Chief Economist Torsten Slok also points out that there is a clear premium in the current 10-year yield. Under normal Fed expectations, the 10-year yield should be near 3.9% rather than the current 4.4%, implying an "excess premium" of about 55 basis points.

The source of this premium may include fiscal worries, quantitative tightening, decreased foreign demand, and doubts about Fed independence. Slok says:

Investors need to seriously consider what these 55 basis points really mean.

Meanwhile, U.S. Treasuries have consistently underperformed SOFR swaps since February 27, with even 2-year bonds starting to lag SOFR swaps, suggesting the market is pricing in risk of increased Treasury supply.

Real Pricing in the Bond Market is Fiscal Stimulus, Not Monetary Easing

Hornbach from Morgan Stanley offers a deeper interpretive framework in his report.

He believes that the current pricing logic of the U.S. Treasury market may already be reflecting not only the monetary policy path, but also anticipating the government’s fiscal response to the energy shock.

From historical experience, the COVID pandemic profoundly changed investors’ perception of crisis response mechanisms.

Before the pandemic, the market assumed central banks were the main tools in a crisis; nowadays, investors seem to believe that fiscal policy has become the main force to respond to growth risks, while central bank response is constrained by ongoing inflation pressure.

In the current situation, Hornbach points out that if investors are pricing in a type of fiscal stimulus significant enough to force the Fed to pivot, its scale must far exceed military supplement appropriations for the Iran conflict, and must cover the private sector hit hardest by rising energy costs.

Morgan Stanley’s public policy strategists think the political path to such supplemental appropriations is already challenging, and whether space for additional stimulus can open depends heavily on the duration of the conflict.

There are precedents already. The Spanish government has proposed a €5 billion energy price relief plan, including VAT reductions and subsidies; Portugal passed legislation allowing temporary price caps on electricity during energy crises.

Potential Risk of Gulf Countries Selling U.S. Treasuries

While expectations of fiscal stimulus heat up, a potential hedging risk is emerging.

Morgan Stanley data shows that holdings by foreign official institutions in New York Fed custody accounts have decreased by about $58 billion since February 25, while foreign monetary authorities’ reverse repo accounts (FIMA RRP) only increased by about $3 billion, meaning the resulting sales proceeds may have been repatriated to home countries, not kept within the U.S. dollar system.

Kuwait, Saudi Arabia, and the UAE together held about $313 billion in U.S. Treasuries as of January this year, and all three have increased holdings since 2022.

Against the backdrop of ongoing conflict, there is still high uncertainty over whether more Gulf countries will reduce their U.S. Treasury holdings to cope with domestic military and economic pressures. This variable, combined with fiscal stimulus expectations, forms a dilemma currently facing the bond market:

On the one hand, fiscal stimulus expectations suppress yields;On the other hand, potential continued selling pressure from the Gulf states might push long-term yields back up, and could force the Fed to act faster if it appears in the long end of Treasuries.

Hornbach admits that how this contradiction will eventually be resolved remains unclear. However, the recent simultaneous surge in gold, precious metals, and crypto assets has shown clearly that the market is actively positioning for some outcome among these scenarios.

Risk Warning and DisclaimerThe market carries risk, and investments should be made cautiously. This article does not constitute personal investment advice, nor does it consider any individual user's particular investment objectives, financial situation, or needs. Users should consider whether any opinions, viewpoints, or conclusions in this article suit their specific circumstances. Invest accordingly at your own responsibility. ```