Fed Rate Cut Hopes Fade as Iran Conflict Deepens
Markets reprice rate expectations as the U.S.-Israeli coalition's conflict with Iran sends energy costs surging and inflation fears back to the fore.
- War between the U.S.-Israeli coalition and Iran has sharply reduced expectations for Fed rate cuts in 2026
- Brent crude breached $85/barrel after the Strait of Hormuz closure, threatening to reignite inflation
- The probability of three rate cuts this year has dropped from ~50% to 21.6% in a single week
- Fed officials are divided — but nearly all are hitting pause on prior guidance
The outbreak of hostilities between the U.S.-Israeli coalition and Iran has done in one week what months of economic data could not: it has fundamentally shifted how markets view the Federal Reserve’s path forward.
Traders are rapidly unwinding bets on multiple rate cuts this year. The probability of three quarter-point reductions in 2026 has collapsed to roughly 21.6%, down from nearly 50% just days ago.
At the June meeting, the CME FedWatch Tool now places a 63% chance on the Fed holding steady — up from around 50% before the conflict escalated. A small but growing share of the market — 8.8% — is now pricing in no cuts at all for the remainder of the year.
The driving force is oil. Brent crude punched through $85 a barrel following the closure of the Strait of Hormuz, a chokepoint through which roughly 20% of global oil supply passes. Goldman
Sachs estimates that a sustained 10% rise in oil prices tacks on approximately 28 basis points to CPI. If the conflict drags on, analysts warn total inflation could rise by as much as 0.6 percentage points — enough to seriously complicate the Fed’s calculus.
The yield curve is already reflecting the shift. The spread between December 2026 and December 2027 SOFR futures dropped to negative 15 basis points, a signal that markets are increasingly betting on inflation staying sticky rather than fading.
Fed officials, for their part, are being careful with their words – but the message is clear enough
Neel Kashkari of the Minneapolis Fed said the conflict has “reduced the certainty” of his prior expectation for at least one cut this year, adding that the Fed needs to see how long elevated energy prices persist before making any moves. John Williams of the New York Fed offered little more than a wait-and-see posture, calling it too early to assess the full economic fallout.
Behind the scenes, the Fed remains divided. Doves still see a scenario where inflation cools later in the year as the conflict’s initial shock fades. Hawks are less charitable — they’re focused on the risk of 3% inflation becoming entrenched, a level that would make cutting rates politically and economically difficult to justify.
J.P. Morgan’s strategists are holding to a baseline of one cut for 2026, though they’ve all but written off the upcoming March meeting as a live option.
The war’s fingerprints are visible in asset markets beyond rates. Gold, often the instinctive refuge in geopolitical crises, dropped 4.4% in a single session as investors pivoted instead to the U.S. dollar — a sign that rising yield expectations, not fear alone, are driving positioning.
The irony isn’t lost on those who spent the past year expecting a clean monetary easing cycle. A conflict thousands of miles away, playing out through a narrow shipping lane, may prove to be the most consequential variable the Fed faces in 2026. And unlike inflation data or labor reports, it’s one the central bank has no tools to control.
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