The most significant change? U.S. debt "decoupling," and the market is sensing the scent of "global fiscal stimulus."

Iran’s conflict is entering its second month, and the market is shifting from pricing in short-term inflation panic to looking ahead to fiscal stimulus.

On Monday, as WTI crude oil broke above $100 per barrel, U.S. Treasury yields—rarely—moved lower in the opposite direction; the 10-year Treasury yield fell by nearly 8 basis points to 4.348%.

Market pricing shifted in sync. In the money market, the probability of the Fed raising rates in 2026 was cut from about 35% last Friday to about 20%, and expectations were reset to modest rate cuts later this year.

This “decoupling” move marks the market beginning to move from short-term inflation panic to concerns about a mid-term economic recession, along with an early positioning for the next round of fiscal stimulus.

Goldman analyst Chris Hussey said the market’s core focus this week still comes down to a tug-of-war between growth and inflation:

• On the inflation side, oil, natural gas, aluminum, and derivatives prices spiral higher, threatening to penetrate globally—especially Asia;
• On the growth side, ongoing uncertainty in the Middle East situation combined with energy price shocks is making the labor demand outlook look bleak.

Although the short-term path may still be complex, Goldman’s view is that across multiple scenarios, bond yields will ultimately fall, long-term equity volatility will rise, and the market will then face “growth panic,” not “persistent inflation panic.”

Morgan Stanley’s chief rates strategist Matthew Hornbach went one step further, proposing that the U.S. rates market may increasingly be reflecting an expectation that after energy-driven demand destruction, fiscal stimulus will follow.

Decoupling in correlation: bond market and oil market diverge

Since the outbreak of the Iran conflict, the market’s pricing logic has been fairly single-minded: go long energy and short everything else.

However, a crack appeared over the past week. Despite the surge in energy prices, long-term inflation expectations have barely moved up. Measured by 5-year inflation swaps, the market’s inflation expectations for the next 5 years have fallen by about 20 basis points from the January peak, retreating to the level seen during last April’s turbulent period.

Francisco Simón, Head of European Strategy at Santander Asset Management, said:

Even though inflation remains a lurking concern, potential drag on growth and confidence should begin to form a hedge, limiting further upward pressure on yields.

He added that the bond market is currently one of the clearest tools for capturing macro impacts created by pricing conflicts.

Apollo Chief Economist Torsten Slok also pointed out that there is a clear premium embedded in current 10-year rates. Under normal Fed expectations driven by the outlook, the 10-year rate should be around 3.9%, not the current 4.4%, implying an “excess premium” of about 55 basis points.

The source of the premium could include fiscal concerns, quantitative tightening, a decline in foreign demand, and doubts about the Fed’s independence. Slok said:

Investors need to think seriously about what these 55 basis points actually mean.

Meanwhile, Treasuries’ performance versus SOFR swaps has continued to weaken since February 27, and even 2-year Treasuries have begun to lag behind SOFR swaps, suggesting the market has already been pricing in the risks of increased Treasury supply.

The bond market’s real pricing is fiscal stimulus, not monetary easing

In a report, Hornbach of Morgan Stanley proposed a deeper interpretive framework.

He believes that the pricing logic in the U.S. Treasury market may no longer be only reflecting the path of monetary policy, but may instead be anticipating the government’s fiscal response to an energy shock.

Looking at historical experience, the COVID-19 pandemic profoundly changed investors’ understanding of the mechanisms for dealing with crises.

Before the pandemic, the market assumed that the main tools for responding to crises came from central banks; now, investors seem to believe that the main force to address a growth crisis has shifted toward government fiscal policy, while central bank reactions are constrained by persistent inflation pressures.

In the current situation, Hornbach noted that if investors are indeed pricing in some kind of fiscal stimulus large enough to force the Fed to change course, its size must far exceed the military supplemental appropriations related to the Iran conflict; it must cover the private sector where the shock from rising energy costs is most severe.

Morgan Stanley public policy strategists said that the political bargaining path for supplemental appropriations has already been full of challenges, and whether room can open up for additional stimulus measures depends largely on how long the conflict lasts.

There is precedent. The Spanish government proposed an energy price relief package of 5 billion euros, covering VAT relief and subsidies; the Portuguese government, through legislation, allowed temporary electricity price caps to be implemented in the event of an energy crisis.

The potential risk of Gulf states dumping U.S. Treasuries

As expectations for fiscal stimulus heat up, a potential hedging risk is emerging.

Morgan Stanley’s data show that foreign official institutions’ holdings in Federal Reserve custodial accounts have declined by about $58 billion since February 25, while over the same period foreign monetary authorities’ reverse repo accounts (FIMA RRP) increased by only about $3 billion, which means the funds obtained from the related selling may have already been repatriated to their home countries rather than being retained within the dollar system.

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

Against the backdrop of ongoing conflict, whether more Gulf countries will reduce their holdings of U.S. Treasuries to cope with domestic military and economic pressures remains highly uncertain. With this variable layered on top of fiscal stimulus expectations, it creates the two-sided dilemma the bond market is facing today:

• On the one hand, fiscal stimulus expectations are pushing yields lower;
• On the other hand, potential ongoing selling pressure from the Gulf states could push long-end yields up again, and if long-end Treasuries appear, could force the Fed to take action sooner.

Hornbach admitted that how this contradiction will ultimately be resolved is still unclear. However, the recent synchronized surge in gold, precious metals, and crypto assets has clearly shown that the market is actively positioning for some outcome under the scenarios above.