Tensions between the US and Iran are escalating, but the bond market is betting on a "2022-style rate hike"? UBS: That's not realistic

Tight Middle East tensions are pushing global bond yields higher, and the market has started to bet that major central banks will replay the 2022 synchronized rate-hike script. But UBS Group’s chief strategist Bhanu Baweja warns that this logic rests on a fundamental misreading.

Baweja said in an interview with Bloomberg TV, “The way the market is pricing things feels like we’re back in 2022—bundling all central banks’ actions together—but the situation right now is completely different.”

He believes the European Central Bank, the Federal Reserve, and the Bank of England are more likely to respond in an “asymmetric” manner—each on its own—rather than moving in lockstep to raise rates. In his view, a supply shock in the fuel markets is more likely to weigh on economic growth and, in turn, limit the room for central banks to further tighten policy.

The above remarks have direct implications for bond investors. Baweja noted that U.S. and U.K. short-dated bonds show signs of being undervalued after yields surged, and investors willing to go against the market may find value there.

Market pricing to replay the 2022 rate-hike logic

Since the Middle East conflict broke out in late February, the market has significantly raised expectations for rate hikes in major economies, driving sustained increases in government bond yields across countries. Swap market pricing indicates that investors have essentially stripped out expectations that the European Central Bank, the Federal Reserve, and the Bank of England will cut rates within the year.

On Tuesday, European bonds fell, with the short end posting especially sharp declines, while money markets further priced in tightening. Germany’s two-year government bond yield rose by 6 basis points to 2.68%, while U.S. Treasuries weakened across the board.

Baweja said the pricing for U.S. and U.K. government bonds is particularly distorted, reflecting expectations that inflation pressures will force central banks to initiate a new round of rate hikes similar to the 2022 cycle. He named it directly: “From the perspective of the fixed income market, the short end is forming value—especially in the U.K., especially in the U.S.”

The fuel-shock logic and a fundamental difference from 2022

Baweja emphasized that the current energy price shock differs from 2022 in the key mechanisms through which it transmits.

The current disruption in the fuel market is more likely to erode economic momentum rather than simply export inflation—meaning central banks will face downside growth pressure, not necessarily a demand overheating that must be curbed via rate hikes.

Against this backdrop, even if inflation data rises in the short term due to higher energy prices, central banks are unlikely to ignore growth risks and tighten aggressively the way they did in 2022.

The macro environment facing the Bank of England and the Federal Reserve has structurally changed compared with three years ago. Tying the three institutions’ policy paths together and ignoring their respective, differentiated constraints is therefore misplaced.

No matter where geopolitics goes, short-dated bonds remain attractive

Baweja provides an asymmetric risk-reward framework for his view: no matter how the situation evolves, short-dated bonds’ risk-reward profile is currently tilted in favor.

“If the situation is smoothed out, fixed income—especially the short end—will perform far better than the losses it would suffer if things deteriorate,” he said.

In other words, if geopolitical risk cools and rate-hike expectations fade, short-dated yields will have significant room to move lower; and even if tensions persist, the pressure on the economy itself will limit the actual magnitude of central banks’ rate hikes.

The market is still in a wait-and-see mode. On the one hand, it is assessing signals that Middle East tensions may ease; on the other, it is watching statements about whether Trump’s threats—if he fails to reach an agreement by 8:00 p.m. Eastern Time on Tuesday—will escalate strikes against Iranian infrastructure. This window of uncertainty is precisely the reason, in Baweja’s view, that the value of short-dated bonds has not yet been fully recognized.

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