Bond investors have retreated to defensive positions as the conflict in the Middle East reintroduced a fresh layer of market risk, prompting a notable move into short-term U.S. Treasuries ahead of this week’s Federal Open Market Committee meeting.
Market participants widely expect the FOMC to maintain its target for the federal funds rate in the 3.50%-3.75% range at the conclusion of the two-day meeting on Wednesday, as policymakers weigh how the Iran war could affect their dual mandate of price stability and maximum employment.
Despite the new geopolitical uncertainty, many investors remain of the view that the confrontation will be short-lived and contained, a judgement that would limit the pass-through of higher oil prices into broader inflation. That scenario, some investors argue, would keep consumer prices relatively stable and could allow the Federal Reserve scope to lower rates later in the year - a development that would likely trigger a rally across U.S. Treasuries and much of the wider fixed-income market.
For the moment, however, the confluence of heightened geopolitical tensions, signs of sticky inflation and a weakening labor market has complicated the outlook for Fed policy, according to portfolio managers. The uncertainty has encouraged many investors to steer clear of longer-duration bonds until they gain clearer visibility about the trajectory of the conflict and the Fed’s response.
"Investors are more cautiously positioned and have avoided riskier parts of the bond market," said Danny Zaid, portfolio manager at TwentyFour Asset Management. "Volatility in rates is going to continue to be high. We continue to be neutral in duration at least until we get more clarity on the conflict."
Duration is a measure of a bond’s sensitivity to interest-rate changes. Maintaining a neutral duration generally means aligning a portfolio’s average maturity with that of its benchmark - for example, holding securities maturing around five years if the benchmark duration is five years. In the current environment, a neutral duration stance reflects a cautious approach that sidesteps lengthening exposure for the time being.
J.P. Morgan’s most recent Treasury Client Survey indicated that the bank’s active clients are carrying the largest outright short positions since early February, a positioning move intended to limit interest-rate risk. In March, two-year yields climbed 31 basis points, putting them on pace for their largest monthly rise since October 2024 - a move that reflects concerns central banks may not be able to cut rates if higher oil prices feed into inflation.
U.S. two-year yields were last reported at 3.69%. Many market participants see potential for two-year yields to decline, noting that short-term Treasuries have already taken much of the selling pressure since the war began, lifting yields to seven-month highs.
Energy markets have been volatile amid the conflict: U.S. crude futures have surged 46% this month, on course for their biggest monthly gain since May 2020. That jump in oil has intensified debate about the inflationary path and the resulting implications for central-bank timing on policy easing.
"There’s a tipping point where the increase from energy-driven inflation becomes demand destruction that starts to reduce consumer spending," said Brad Conger, chief investment officer at Hirtle Callaghan in Philadelphia. "Treasuries are a hedge against a slowdown in the economy whether the war ends quickly or whether it drags on."
In line with the change in market sentiment, U.S. rate futures have largely stopped pricing in a Fed cut this year. Current market pricing reflects just 24 basis points of easing, down from 55 basis points before the onset of the conflict, based on LSEG estimates.
"Rates to me are becoming an opportunity, particularly on the front end of the curve. You’re eliminating most cuts in the near term," said Seth Meyer, global head of client portfolio management at Janus Henderson Investors.
The Fed’s guidance and economic outlook will come into sharper relief on Wednesday, when policymakers release the summary of economic projections, including the rate forecasts known as the "dot plot." At the December meeting, when the Fed last adjusted policy into the current 3.50%-3.75% range, the dot plot showed only one additional 25-basis-point easing expected for the year. At that time, the median policymaker’s estimate of the neutral policy rate - the level neither contractionary nor stimulative - remained at 3%.
Overall, investors do not anticipate a significant shift in Fed guidance at the forthcoming meeting as the Iran conflict continues to unfold. "Determining the next step is anybody’s guess at this point," said Olumide Owolabi, head of the U.S. rates team at Neuberger Berman. "I don’t see the Fed changing its long-term outlook...just because the level of uncertainty is super elevated."
Implications for markets
- Short-term Treasuries have attracted demand as investors seek to limit interest-rate and duration risk.
- Higher oil prices are feeding uncertainty around inflation and the timing of potential Fed easing.
- Positioning has shifted toward shorter maturities and increased outright short exposure among active clients, reflecting caution ahead of clearer signals from both geopolitical developments and central-bank guidance.