War Shock, Yield Repricing and Central Bank Pauses That No Longer Feel Dovish

Executive Summary

Central banks are in a reluctant holding pattern. The Fed, BoE, ECB and others have paused, but futures curves now lean toward “no cuts” and assign a non‑zero probability to hikes as policy credibility collides with energy‑driven inflation.

U.S. Yields and War‑Driven Scenarios

The Iran conflict and the accompanying surge in energy prices are forcing a rapid reset in global rate expectations, with inflation breakeven rates grinding higher and policy‑sensitive yields starting to challenge central banks’ “on hold” stance. The result is a wider, and more uncomfortable distribution of outcomes for investors who, only weeks ago, were debating how many cuts they might get in 2026, not whether the next move could be a hike.

The U.S. 2‑year breakeven inflation expectation has climbed to 3.2%, up from 3.0% before the Iran war, signaling that investors see a more persistent inflation impulse rather than a fleeting commodity shock. At the long end, real yields are mostly higher since the conflict began, and the nominal 10‑year Treasury has set its sights on 4.5% (currently around 4.32%) as inflation premia rebuild along the curve. In a shorter war scenario, where hostilities materially wind down from April through Q2, inflation expectations may back off their peaks but remain structurally elevated, limiting how far market rates can fall. In that environment, the 10‑year could drift back toward 4% and hold there, keeping real borrowing costs restrictive.

Prolonged war is more troubling. Here, persistent conflict and cost shocks place risk assets under heavy pressure, recession odds rise, and real rates collapse as investors reach for safety. Inflation risk does not disappear, however, but growth angst dominates. Under this path, the 10‑year Treasury could slice through 4% and trade closer to 3.75% or below, with 10‑year SOFR around 3.3%, a configuration that looks less like a benign disinflation and more like a flight‑to‑ quality bid into an unfolding downturn.

Against this backdrop, front‑end pricing has shifted meaningfully. Policy‑sensitive yields and Fed expectations are now being pulled higher by energy and geopolitical risk, even as recession scenarios linger in the tails.

Fed: From Cuts Debate to “No Cuts” Baseline

The Federal Reserve kept its benchmark rate at 3.50%–3.75% last week, extending a wait‑and‑see posture that now feels more hawkish in market terms than on paper. Most officials still pencil in at least one 25‑basis‑point cut this year, but the dot plot remains deeply split: seven of 19 policymakers see no cuts in 2026, while five anticipate 50 basis points or more in easing.

Futures markets are quietly siding with the hawkish cohort. Before the Iran war, Fed funds futures were pricing moderately high odds of a June cut; now, standing pat is considered the base case for roughly the next seven meetings through January 2027. Rate hikes are not the central scenario, but the curve has begun to price in non‑zero odds of an upward move as a nod to persistent inflation risk.

The Treasury market is echoing that shift. For the first time in more than a year, the 2‑year Treasury yield (approximately 3.87% and up nearly 50 basis points from its early March low) now trades above the median effective Fed funds rate (3.64%), a configuration that traditionally signals at least some probability that the policy rate will need to move higher to validate market pricing.

That dynamic has not been lost on market participants. “We are not anticipating a rate cut until at least June, while also recognizing there is now a growing and non‑zero chance that the next rate move may actually be up,” Trent Scott, CCIM, president of First Capital Property Group/CORFAC International, told Connect Money, pointing to the risk that new inflation shocks linger longer than the Fed expects.

Bank of England, ECB and Others with Hawkish Holds

The Bank of England underscored the global pivot last week, delivering what amounted to a hawkish hold. Rather than cutting as many had anticipated before the conflict, the BoE kept its key rate at 3.75%, explicitly linking its stance to the inflationary impact of the Middle East war on energy and input costs. Policymakers stressed they would act to counter any rise in inflation that looks persistent, but also emphasized unusually high uncertainty and the need for greater clarity before committing to a new path for rates.

Before U.S. and Israeli strikes on Iran late last month, markets had broadly expected the BoE to ease. The conflict, however, has driven energy prices sharply higher and is likely to push up fertilizer costs, setting the stage for a renewed bout of food inflation in the U.K. and beyond.

The BoE’s decision puts it in line with a growing list of central banks—the Fed, Bank of Canada, Bank of Japan, European Central Bank, and the Riksbank and Swiss National Bank—that have all opted to hold rates steady while warning that the Iran war could reshape their inflation and growth outlooks. For the ECB, markets have now swung from debating cuts to pricing in more than 50 basis points of tightening this year, with a first hike fully discounted by June as investors reassess how long energy‑driven price pressures will linger.

U.K. Gilts, German Bunds Send Signal

The 2‑year sovereign yields in Europe are now firmly aligned with this higher‑for‑longer narrative. In the U.K., the 2‑year Gilt yield is trading 65 basis points above the BoE’s 3.75% policy rate at 4.41%, reflecting increased odds that a cut is a distant prospect and that a hike cannot be ruled out if energy and food inflation re‑accelerate. Across the Channel, the 2‑year German Bund yield is trading at 2.59%, up a whopping 60 basis points since the war began and has pushed higher alongside rising ECB hike expectations.

War‑driven energy shocks are re‑inflating term premia, forcing central banks to defend their inflation targets from above rather than cushioning growth from below. Whether the next chapter brings substantially higher global rates anchored by sticky inflation or a sharp move lower driven by growth fears, the era of easy rate‑cut consensus is over—for now.

We want to hear your views.

Are markets underestimating the risk that the next Fed move could be a hike rather than a cut?

What level of the 10-year yield begins to break something in the system—4.5%, 5%, higher?

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