U.S. debt "decoupling" Market senses the scent of "global fiscal stimulus"

Author: Bao Yilong, Wall Street Insights

As the Iran conflict enters its second month, the market is shifting from short-term inflation panic to forward-looking pricing of fiscal stimulus.

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

Market pricing has shifted in tandem. The money market has cut the probability of the Federal Reserve raising rates in 2026 from roughly 35% last Friday to roughly 20%, and has instead repriced its expectations for a modest rate cut this year.

This “decoupling” trend signals that the market has started to move from short-term inflation panic to concern about a mid-term economic recession, and to make an early layout for the next round of fiscal stimulus.

Goldman Sachs analyst Chris Hussey noted that the tug-of-war between growth and inflation remains the market’s core this week:

On the inflation side, oil, natural gas, aluminum, and derivative prices spiral higher, threatening penetration globally—especially into Asia;

On the growth side, persistent uncertainty in the Middle East combined with an energy price shock has made the labor demand outlook look increasingly bleak.

Even though the near-term path could still be complex, Goldman’s view is that, under multiple scenarios, bond yields will ultimately fall and long-term equity volatility will rise. What the market will face then is “economic growth panic,” not “persistent inflation panic.”

Morgan Stanley’s chief rates strategist Matthew Hornbach went even further, suggesting that the U.S. rates market may increasingly be reflecting a scenario in which, after energy-driven demand destruction, fiscal stimulus will follow.

Correlation decouples: bond and oil markets diverge

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

However, cracks appeared over the past week. Even as energy prices surged, long-term inflation expectations barely moved higher. Measured by five-year inflation swaps, the market’s inflation expectations for the next five years have fallen by about 20 basis points from the January peak, returning to the level seen during the volatile period of last April.

Francisco Simón, head of European strategy at Santander Asset Management, said:

While inflation remains an underlying concern, the potential drag on growth and confidence should begin to be offset and therefore limit any further rise in yields.

He added that the bond market is currently one of the clearest tools for gauging macro impacts amid pricing conflicts.

Apollo chief economist Torsten Slok also pointed out that there is a clear premium embedded in current 10-year yields. Under normal expectations driven by the Federal Reserve, the 10-year yield should be around 3.9%, not the current 4.4%—implying an “excess premium” of roughly 55 basis points.

The source of the premium could include fiscal worries, quantitative tightening, a decline in offshore demand, and doubts about the independence of the Federal Reserve. Slok said:

Investors need to take seriously what those 55 basis points actually imply.

Meanwhile, the performance of Treasuries relative to SOFR swaps has continued to weaken since February 27. Even the 2-year Treasury has started to lag SOFR swaps, suggesting that the market has begun pricing risks related to an increase in Treasury supply.

Bond market’s true pricing is fiscal stimulus, not monetary easing

Hornbach of Morgan Stanley’s report proposed a deeper analytical framework.

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

Based on historical experience, the COVID-19 pandemic profoundly changed investors’ understanding of crisis-response mechanisms.

Before the pandemic, the market assumed that the primary tools for handling a crisis came from the central bank. Now, investors seem to believe that the main force in addressing a growth crisis has shifted to government fiscal policy, while central bank action is constrained by ongoing inflation pressure.

In the current situation, Hornbach noted that if investors are truly pricing some kind of fiscal stimulus large enough to force the Fed to turn, its scale must far exceed the military supplemental appropriations related to the Iran conflict, and must cover the private sector whose energy-cost shock is the most severe.

For Morgan Stanley’s public policy strategists, the political bargaining path for supplemental appropriations is already challenging. Whether there is room to open additional stimulus measures depends largely on how long the conflict lasts.

There is already precedent. The Spanish government proposed a EUR 5 billion energy price relief plan, 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.

Potential risk of Gulf states selling U.S. Treasuries

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

Morgan Stanley’s data shows that the foreign official sector’s holdings in the New York Fed’s custody accounts have fallen by about $58 billion since February 25, while, over the same period, the foreign currency authorities’ reverse repo accounts (FIMA RRP) increased by only about $3 billion. This means that the proceeds from the related selling may already have been sent back to the home country, rather than being kept within the U.S. dollar system.

The three countries of Kuwait, Saudi Arabia, and the UAE held a combined total of about $313 billion in U.S. Treasuries in January this year, and their holdings have all grown since 2022.

Against the backdrop of a continuing conflict, whether more Gulf states will trim their holdings of U.S. Treasuries to respond to domestic military and economic pressures remains highly uncertain. With this variable layered on top of fiscal stimulus expectations, it creates the dilemma the bond market is facing today:

• On the one hand, fiscal stimulus expectations push yields down;

• On the other hand, potential sustained selling pressure from Gulf states could push up long-end yields again and, if long-end Treasuries come under pressure, force the Fed to act more quickly.

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