U.S. Treasury bonds are pricing in a "rate hike"? More precisely, the market is pricing in "QE"!
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In the face of escalating geopolitical conflicts in the Middle East and surging oil prices, the U.S. interest rate market has shown a bizarre pricing for rate hikes: last Friday, the market once priced the probability of a Fed rate hike in December this year at over 50%.
Morgan Stanley’s rate strategy team pointed out in their latest report that although the U.S. Treasury market appears to be pricing in a Fed rate hike at year-end, it is actually pricing in advance for an imminent launch of a super-large “fiscal stimulus” by the U.S. government.
The team believes that in the post-pandemic era, investor expectations for crisis policy responses have fundamentally shifted: instead of waiting for the central bank to cut rates and rescue the market, the bet is now on direct “fiscal filling.”
This paradigm shift is reshaping the risk-hedging logic of U.S. Treasuries and the entire macro trading framework.
Bizarre Rate Hike Pricing: What Is the Market Really Expressing?
The Iran conflict has entered its third week, and the U.S. interest rate market is seeing a rare scene: last Friday, the probability of a December rate hike exceeded 50%.
Comparing the Fed's March dot plot and the New York Fed's survey of primary dealers and market participants, the current implied path for the federal funds rate is much higher than expected at all time points—such a dramatic divergence has left many investors confused.
To explain this divergence, Morgan Stanley’s rate strategy team used a clever backwards probability calculation.
MS compared four macro scenarios predicted by their economists—baseline (55%), demand up (10%), productivity up (15%), mild recession (20%)—with market pricing. The result shows that the economists’ probability-weighted terminal federal funds rate is 3.24%, while market pricing is as high as 3.63%.
To match this market pricing, MS found the probabilities had to be adjusted extremely: the probability for “demand up” must be raised from 10% to 41%, “productivity up” to 59%, and both baseline and mild recession probabilities reduced to zero.
This means the market has almost completely ruled out the possibility of an economic slowdown, betting wholly on a strong demand growth pulse.
In the context of an energy shock and surging oil prices, this pricing seems irrational—unless the market is convinced that there exists a huge external force sufficient to offset the energy burden.
The answer Morgan Stanley offers: an unexpected fiscal stimulus.
From “Central Bank Rescue” to “Government Filling”—A Post-pandemic Paradigm Shift
MS wrote in the report:
“The U.S. rate market is focused on an interventionist government, rather than an interventionist central bank.”
The team pointed out that the pandemic and its aftermath have fundamentally changed investors’ perceptions of crisis policy responses.
Before the pandemic, the market’s reflex was clear: growth crisis → central bank rate cut → buy Treasuries. Now, investors seem to have developed a new belief—when confronted with a growth crisis, the first actor is not the central bank, but the government. Because the central bank is busy dealing with waves of inflation problems, it may react too slowly or too late.
In the U.S., investors appear to be “seeing through” high oil prices’ demand-destroying effects, and instead pricing in the “filling” effect of fiscal stimulus.
If fiscal stimulus fills the demand gap caused by high oil prices, then energy inflation will “exist in isolation”—that is, demand does not collapse but inflation stays high, which then would force the Fed to abandon easing, or even turn hawkish.
Multiple clues are supporting this shift in macro expectations:
- The abnormal trend of inflation expectations. The 1-year forward 1-year (1y1y) CPI inflation swap rate tracked by MS rose after the conflict erupted (in contrast to its fall after the “Liberation Day” incident last April). As long as oil prices and the 1y1y inflation swap show a positive correlation, oil prices have not reached the critical point destroying demand. The flip side is, the market may expect the government to act before demand is destroyed.
- Europe offers precedent. The Spanish government proposed a €5 billion energy relief package, including VAT reductions and subsidies; the Portuguese government approved a law allowing temporary electricity price caps during the energy crisis.
But MS emphasized: fiscal stimulus, to explain current U.S. Treasury pricing, must far exceed military supplementary appropriations incurred by the Iran conflict. At present, the Pentagon has acquired about $840 billion in FY26 base defense appropriations, plus around $150 billion in supplementals via OBBBA. MS believes the Treasury will likely issue T-bills to finance these supplementary appropriations. The media-reported extra supplementary funding of about $200 billion, MS public policy strategists think, is hard to pass. Pure military appropriations are not enough to create a growth pulse that could force the Fed to pivot—the fiscal package the market prices in must directly target private sectors hit hardest by energy costs.
Notably, MS’s public policy strategists further noted that political games around supplementary appropriations—and any targeted fiscal policies linked to economic conditions—could shift as the conflict continues. The longer the conflict endures, the higher the chance for supplementary appropriations to pass, with extra economic stimulus likely piggybacking alongside.
Other market signals are confirming expectations of fiscal expansion:
U.S. stocks are more resilient than expected—the S&P 500 has only fallen about 6% since February 27, much better than the 13% drop when the Russia-Ukraine conflict escalated. U.S. Treasuries have underperformed relative to SOFR swaps—the 30-year Treasury-SOFR spread has fallen by 10 basis points since February 27, and even before new capital rules were announced, the 2-year Treasury was already underperforming SOFR swaps, a classic signal of market concerns over increased Treasury supply.
Meanwhile, Treasuries have failed to provide expected hedging protection as risk assets fell—not just because the Fed is not dovish enough, but also because the market is pricing in more Treasury supply resulting from fiscal expansion.
$58 Billion Sell-off—Are Middle Eastern Heavyweights Cashing Out?
Adding to the woes for U.S. Treasuries, besides the massive supply expectations from internal fiscal expansion, real selling pressure from abroad is incoming: Middle Eastern countries may be cashing out on a large scale.
The report reveals that by January 2026, Kuwait, Saudi Arabia, and the UAE together hold as much as $313.5 billion in U.S. Treasuries, and all three nations have tended to increase holdings since 2022.
However, New York Fed custody data raised a loud alarm: Since February 25 (when the conflict broke out), foreign monetary authorities have net sold about $58 billion in U.S. Treasuries.
The destination of these funds is even more alarming.
During the same period, the New York Fed’s reverse repo facility (FIMA RRP) for foreign monetary authorities only increased by $3 billion—meaning the sell-off proceeds did not flow back into the Fed’s “safe haven,” but likely truly left the U.S. Treasury market.
Given the conflict, the market has reason to suspect that Middle Eastern countries are liquidating Treasuries to raise funds for defense and potential repair of damages.
Underestimated Paradigm Shift: No Longer Waiting for Central Bank Rescue, but Betting on Direct Fiscal “Filling”
Facing this complex situation, MS advises investors to keep a neutral stance on duration and curve direction in U.S. Treasuries, waiting for more clarity on the impact of the Iran conflict on monetary and fiscal policies.
On the trading side, MS maintains a position favoring a wider spread in the 2-year (September 2027 maturity) U.S. Treasury-SOFR swap, holding long at -14.8bp with a target of -14bp and a trailing stop at -18.5bp.
However, beyond specific trade levels, what this report truly offers for investors to ponder is a paradigm shift that may have been underestimated: in the post-pandemic world, as the market begins to see fiscal stimulus—not central bank rate cuts—as the first response tool in crisis, Treasuries’ risk-hedging attributes, inflation expectation pricing logic, and even the entire macro trading framework all need recalibration.
The market superficially prices “rate hikes,” but is actually pricing “QE”—except this time, the protagonist is not the Fed, but the U.S. government.
Risk Warning and DisclaimerThe market has risks; investments require caution. This article does not constitute personal investment advice, nor does it consider the specific investment objectives, financial situations, or needs of individual users. Users should consider whether any opinions or conclusions in this article suit their particular circumstances. Investment decisions based on this article are at your own risk. ```