Are US Treasuries Pricing in Rate Hikes? More Precisely, the Market is Pricing in Quantitative Easing!

Faced with escalating Middle East geopolitical conflicts and soaring oil prices, the U.S. interest rate market has shown a strange pricing of rate hikes: last Friday, the market briefly priced in a greater than 50% chance of a Federal Reserve rate hike in December this year.

Morgan Stanley’s Rate Strategy Team in their latest report pointed out that the U.S. bond market seems to be pricing in a Fed rate hike by the end of the year, but in reality, it is pre-emptively pricing in an upcoming massive “fiscal stimulus” from the U.S. government.

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

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

Strange Rate Hike Pricing: What Is the Market Really Saying?

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

Compared with the Fed’s March dot plot and surveys of primary dealers and market participants by the New York Fed, the implied path of the federal funds rate in the current market is significantly higher than expectations at all time points—this stark divergence has left many investors confused.

To explain this sharp divergence, Morgan Stanley’s rate strategy team performed a clever probability reverse-engineering.

They compared four macro scenarios predicted by their economists—baseline (55%), demand up (10%), productivity up (15%), mild recession (20%)—with market pricing. The results showed that the probability-weighted terminal federal funds rate based on economists’ forecasts is 3.24%, while the market is pricing it at 3.63%.

To match this market pricing, Morgan Stanley found it must make extreme probability adjustments: raising the “demand up” scenario from 10% to 41%, “productivity up” to 59%, and reducing the baseline and mild recession probabilities to zero.

This implies that the market has almost completely ruled out the possibility of economic weakening, fully betting on a strong demand surge.

Against the backdrop of energy shocks and soaring oil prices, this pricing seems irrational—unless the market is convinced that some enormous external force exists to offset energy burdens.

Morgan Stanley’s answer: Better-than-expected fiscal stimulus.

From “central bank rescue” to “government filling the gap”—a paradigm shift after the pandemic

Morgan Stanley states in the report:

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

The team notes that the pandemic and its aftermath have fundamentally changed investors’ perceptions of crisis policy responses.

Before the pandemic, market reflexes were clear: growth crisis → Fed rate cuts → buy government bonds. But now, investors seem to have formed a new belief—when facing a growth crisis, it’s no longer the central bank that acts first, but the government. Because the Fed is exhausted dealing with wave after wave of inflation, reacting too slowly or too late.

In the U.S., investors may be “seeing through” the demand-destroying effects of high oil prices and pricing in the “filling the gap” effect of fiscal stimulus.

If fiscal stimulus fills the demand gap caused by high oil prices, energy inflation will be “isolated”—meaning demand remains intact but inflation stays high, which could force the Fed to abandon easing and even turn hawkish.

Multiple clues support this macro expectation shift:

• Unusual inflation expectations. Morgan Stanley’s ongoing tracking of the 1-year forward 1-year (1y1y) CPI inflation swap rate shows that after the conflict erupted, it rose instead of falling (contrary to the decline after the April 2 “Liberation Day” event last year). As long as the positive correlation between oil prices and 1y1y inflation swaps remains, it indicates oil prices have not yet reached a critical point to destroy demand. But on the flip side, the market may be expecting the government to act before demand is destroyed.
• Precedent in Europe. The Spanish government proposed a €5 billion energy relief plan, including VAT reductions and subsidies; Portugal approved a law allowing temporary electricity price caps during the energy crisis.

However, Morgan Stanley emphasizes that the fiscal stimulus needed to explain current U.S. bond pricing must far exceed the military supplemental appropriations related to the Iran conflict. Currently, the Pentagon has secured about $840 billion in FY26 national defense appropriations, plus approximately $150 billion in supplemental funding via OBBBA. Morgan Stanley’s public policy strategists believe the Treasury is likely to finance conflict-related supplemental spending through T-bill issuance. The additional roughly $200 billion reported by the media as supplemental funding is considered difficult to achieve via pathways. Pure military spending alone is insufficient to generate the growth impulse that would cause the Fed to pivot—if the market is truly pricing in a hawkish shift, the fiscal plan expected must directly target the private sector most impacted by energy costs.

It’s worth noting that Morgan Stanley’s public policy strategists further point out that the political battles over supplemental funding—and any targeted fiscal policies linked to economic conditions—may change as the conflict prolongs. The longer the conflict lasts, the higher the probability of approval for supplemental appropriations, and the more likely additional economic stimulus will be passed along.

Other market signals also confirm expectations of fiscal expansion:

• Resilience of U.S. stocks exceeds expectations—the S&P 500 has fallen only about 6% since February 27, much better than the 13% decline during the escalation of the Russia-Ukraine conflict. U.S. Treasuries relative to SOFR swaps have weakened significantly—since February 27, the 30-year Treasury-SOFR spread has decreased by 10 basis points, and even before new capital rules, 2-year Treasuries have started underperforming SOFR swaps, a classic sign of concern over increased Treasury supply.

Meanwhile, Treasuries have failed to provide the expected hedge during risk asset declines—partly due to the Fed’s less dovish stance, and partly because the market is pricing in more Treasury supply driven by fiscal expansion.

$58 billion sell-off—Are Middle Eastern major holders cashing out?

Adding to the Treasury’s woes is the external selling pressure: Middle Eastern countries may be liquidating large amounts of U.S. debt.

The report discloses that by January 2026, Kuwait, Saudi Arabia, and the UAE together hold up to $313.5 billion in U.S. Treasuries, with holdings increasing since 2022.

However, data from the New York Fed’s custody reports sound an alarm: since February 25 (the start of the conflict), foreign official holdings have net sold about $58 billion of U.S. Treasuries.

Where the funds go is even more concerning.

During the same period, the New York Fed’s Foreign and International Monetary Authorities (FIMA) RRP facility only increased by $3 billion—meaning the proceeds from the sales have not flowed back into the Fed’s safe harbor, but likely exited the U.S. Treasury market altogether.

In the context of the conflict, market speculation suggests that Middle Eastern countries are liquidating Treasuries to fund defense and potential sabotage repair efforts.

Undervalued Paradigm Shift: No Longer Waiting for the Fed to Cut Rates, Instead Betting on Direct “Filling the Gap” by the Government

Faced with this complex situation, Morgan Stanley recommends investors remain neutral on the duration and curve of U.S. Treasuries, awaiting further clarity on how the Iran conflict will influence monetary and fiscal policies.

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

However, beyond specific levels, what truly warrants deep reflection is a potentially underestimated paradigm shift: in the post-pandemic world, as markets begin to view fiscal stimulus rather than Fed rate cuts as the primary crisis response tool, the safe-haven attributes of Treasuries, inflation expectations pricing, and even the entire macro trading framework need recalibration.

The market appears to be pricing “rate hikes,” but in reality, it is pricing “QE”—only this time, the protagonist is not the Fed, but the U.S. government.

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