Are U.S. bonds pricing in "rate hikes"? More accurately, the market is pricing in "QE"!

Why has the market shifted from interest rate cut expectations to pricing in fiscal stimulus?

In the face of escalating geopolitical conflicts in the Middle East and soaring oil prices, the U.S. interest rate market has displayed a bizarre pricing for interest rate hikes: last Friday, the market briefly priced in a probability of over 50% for a Federal Reserve interest rate hike in December this year.

Morgan Stanley’s interest rate strategy team pointed out in their latest report that while the U.S. Treasury market seems to be pricing in a Federal Reserve rate hike by the end of the year, it is actually pricing in the upcoming massive “fiscal stimulus” from the U.S. government.

The team believes that in the post-pandemic era, investors’ expectations of policy responses to crises have fundamentally shifted: no longer waiting for the central bank to cut rates to rescue the economy, but instead betting on direct government “fiscal filling.”

This paradigm shift is reshaping the safe-haven logic of U.S. Treasuries and the entire macro trading framework.

Bizarre interest rate hike pricing: What is the market really expressing?

As the Iran conflict enters its third week, a rare scene has unfolded in the U.S. interest rate market: last Friday, the market briefly priced in a probability of over 50% for a rate hike in December.

Comparing with the Federal Reserve’s dot plot from March and the New York Fed’s survey of primary dealers and market participants, the current market-implied path of the federal funds rate is significantly higher than expected at all time points—this drastic divergence has left many investors puzzled.

To explain this drastic divergence, Morgan Stanley’s interest rate strategy team conducted a clever probability backtrack.

Morgan Stanley compared four macro scenarios predicted by its economists—baseline (55%), demand upturn (10%), productivity upturn (15%), and mild recession (20%)—with market pricing. The results showed that the economist probability-weighted endpoint for the federal funds rate was 3.24%, while market pricing reached as high as 3.63%.

To match this market pricing, Morgan Stanley found that extreme adjustments to probabilities were necessary: raising the probability of the “demand upturn” scenario from 10% to 41%, adjusting “productivity upturn” to 59%, while simultaneously reducing the probabilities of the baseline and mild recession scenarios to zero.

This means the market has almost completely ruled out the possibility of economic weakness, betting heavily on a robust demand growth pulse.

In the context of energy shocks and soaring oil prices, this pricing seems absurd—unless the market is convinced that there exists some enormous external force capable of offsetting the energy burden.

Morgan Stanley’s answer is: unexpected fiscal stimulus.

From “central bank rescue” to “government filling”—the post-pandemic paradigm shift

Morgan Stanley wrote in the report:

“The U.S. interest rate market is focusing on an actively intervening government, rather than an actively intervening central bank.”

The team pointed out that the pandemic and its aftermath have fundamentally changed investors’ perceptions of policy responses to crises.

Before the pandemic, the market’s reflex was clear: growth crisis → central bank cuts → buy Treasuries. But now, investors seem to have formed a new belief—that in the face of a growth crisis, the first to act is no longer the central bank, but the government. This is because the central bank is overwhelmed by waves of inflation issues and may react too slowly and too late.

In the U.S., investors may be “seeing through” the demand-destroying effects of high oil prices 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 remains high, which precisely forces the Federal Reserve to abandon easing and even turn hawkish.

Several clues are supporting this macro expectation shift:

• Abnormal trends in inflation expectations. The 1-year forward 1-year CPI inflation swap rate, continuously tracked by Morgan Stanley, has risen rather than fallen after the conflict broke out (in stark contrast to the drop following the “Liberation Day” event on April 2 last year). As long as the positive correlation between oil prices and the 1y1y inflation swap rate remains intact, it indicates that oil prices have not yet reached the critical point of destroying demand. But the flip side is that the market may expect the government to act before demand is destroyed.
• Europe has precedents. The Spanish government proposed a €5 billion energy relief plan, including VAT reductions and subsidies; the Portuguese government approved a bill allowing for temporary electricity price caps during the energy crisis.

However, Morgan Stanley emphasized that the fiscal stimulus needed to explain the current U.S. Treasury pricing behavior must far exceed the military supplemental appropriations related to the Iran conflict. Currently, the Pentagon has received approximately $840 billion in the FY26 base defense appropriations bill and approximately $150 billion in supplemental appropriations through OBBBA. Morgan Stanley believes the Treasury will most likely finance the conflict supplemental appropriations by issuing Treasury bills (T-bills). The additional approximately $200 billion in supplemental appropriations reported by the media is considered difficult to achieve by Morgan Stanley’s public policy strategists. The scale of military appropriations alone is insufficient to generate the growth pulse that would force the Federal Reserve to pivot—if the market is indeed pricing in a hawkish shift, then the anticipated fiscal plan must directly target the private sector that is most impacted by rising energy costs.

It is worth noting that Morgan Stanley’s public policy strategists further pointed out that the political struggle surrounding supplemental appropriations—and any targeted fiscal policies linked to economic conditions—may change as the conflict continues. The longer the conflict lasts, the higher the probability of approval for supplemental appropriations, and the accompanying additional economic stimulus is also more likely to pass.

Other market signals are also corroborating expectations of fiscal expansion:

U.S. stocks have shown resilience beyond expectations—the S&P 500 has dropped only about 6% since February 27, much better than the 13% decline during the escalation of the Russia-Ukraine conflict. U.S. Treasuries have significantly weakened relative to SOFR swaps—since February 27, the 30-year Treasury-SOFR spread has decreased by 10 basis points, and even before the new capital rules were introduced, the 2-year Treasury began to underperform SOFR swaps, which is a classic signal of market concerns about increasing Treasury supply.

At the same time, Treasuries failed to provide the expected hedging protection when risk assets fell—one aspect is that the Federal Reserve is not dovish enough, and the other aspect is that the market is pricing in more Treasury supply brought by fiscal expansion.

$58 billion sell-off—Are Middle Eastern mega-investors cashing out?

Compounding the situation for U.S. Treasuries is the expectation of massive supply from internal fiscal expansion and the impending real selling pressure from abroad: Middle Eastern countries may be cashing out on a large scale.

The report reveals that as of January 2026, Kuwait, Saudi Arabia, and the UAE collectively held as much as $313.5 billion in U.S. Treasuries, and their holdings have been on the rise since 2022.

However, data from the New York Fed has issued alarming warnings: since February 25 (the outbreak of the conflict), foreign currency authorities have net sold approximately $58 billion in U.S. Treasuries.

The direction of the funds is even more concerning.

During the same period, the New York Fed’s reverse repurchase facility (FIMA RRP) for foreign currency authorities only increased by $3 billion—this means that the proceeds from the sales have not returned to the “safe harbor” within the Federal Reserve system, and the funds are likely flowing out of the Treasury market.

In the context of the conflict, the market has reason to speculate that Middle Eastern countries are liquidating U.S. Treasuries to raise funds for defense and potential reconstruction efforts.

An underestimated paradigm shift: No longer waiting for the central bank to cut rates for rescue, but betting on direct government “fiscal filling.”

In the face of this complex situation, Morgan Stanley advises investors to maintain a neutral position on the duration and curve direction of U.S. Treasuries while waiting for further clarity on the impact of the Iran conflict on monetary and fiscal policies.

On the trading front, Morgan Stanley maintains a long position on the 2-year (maturing in September 2027) Treasury-SOFR swap spread, holding long at -14.8bps with a target of -14bps and a trailing stop at -18.5bps.

However, more than specific points, what this report truly invites investors to ponder is a potentially underestimated paradigm shift: in the post-pandemic world, as the market begins to view fiscal stimulus rather than central bank rate cuts as the first response tool to crises, the safe-haven attributes of Treasuries, the pricing logic of inflation expectations, and even the entire macro trading framework will need recalibration.

On the surface, the market is pricing in “rate hikes,” but in reality, it is pricing in “QE”—only this time, the protagonist is not the Federal Reserve, but the U.S. government.