Tensions between the U.S. and Iran are escalating, but the bond market is betting on "2022-style rate hikes"? UBS: That's not realistic

Tensions in the Middle East are driving up global bond yields, and markets are beginning to bet that major central banks will repeat the 2022 synchronized rate hikes. However, UBS Group’s chief strategist Bhanu Baweja warns that this logic contains a fundamental misjudgment.

Baweja stated in an interview with Bloomberg Television, “The market’s pricing is like going back to 2022—bundling all central bank actions together, but the current situation is entirely different.”

He believes that the European Central Bank, Federal Reserve, and Bank of England are more likely to respond in an “asymmetric” manner rather than moving in lockstep with rate hikes. In his view, supply shocks in the fuel market are more likely to dampen economic growth, which could instead constrain central banks from further tightening policies.

This stance has direct operational implications for bond investors. Baweja pointed out that short-term bonds in the U.S. and U.K. have already shown signs of being undervalued due to sharply rising yields, offering value for contrarian investors.

Market Pricing Repeats 2022 Rate Hike Logic

Since the outbreak of conflict in the Middle East in late February, market expectations for rate hikes by major economies have been significantly revised upward, pushing government bond yields higher across the board. Swap market pricing indicates that investors have largely dismissed the possibility of the European Central Bank, Federal Reserve, and Bank of England cutting rates within the year.

On Tuesday, European bonds declined, with the short end falling most notably, as the money market further bets on tightening. The yield on two-year German government bonds rose 6 basis points to 2.68%, while U.S. bonds also weakened across the board.

Baweja believes that the pricing of U.S. and U.K. government bonds is particularly distorted, reflecting expectations that inflation pressures will force central banks to initiate a new cycle of rate hikes similar to 2022. He directly pointed out, “In the fixed income market, the short end is starting to find value, especially in the U.K. and the U.S.”

Fundamental Differences Between Fuel Shock Logic and 2022

Baweja emphasized that the current energy price shocks differ fundamentally in transmission mechanisms from those in 2022.

The current disruptions in the fuel market are more likely to erode economic momentum rather than simply output inflation—meaning central banks will face downside growth risks rather than demand overheating that needs to be curbed with rate hikes.

In this context, even if inflation data temporarily rises due to energy prices, central banks will find it difficult to ignore growth risks and aggressively tighten policies as they did in 2022.

The macro environment faced by the Bank of England and the Federal Reserve has undergone structural changes compared to three years ago. Bundling their policy paths into a single valuation ignores the different constraints each faces.

Regardless of geopolitical developments, short-term bonds remain attractive

Baweja offers an asymmetric risk-reward framework for his view: regardless of how the situation unfolds, the risk-return profile of short-term bonds is currently favorable.

“If the situation resolves smoothly, the performance of fixed income, especially short-term, will far outperform the losses incurred during worsening conditions,” he said.

In other words, if geopolitical risks ease and rate hike expectations decline, short-term yields will have significant downside potential; even if tensions persist, economic pressure will itself limit the actual rate hikes by central banks.

The market remains in a wait-and-see mode, assessing signals that Middle East tensions may ease, while also watching for Trump’s threat that if an agreement is not reached by 8 p.m. Eastern Time Tuesday, he will escalate strikes against Iranian infrastructure. This uncertainty window is precisely why Baweja believes the value of short-term bonds has not yet been fully recognized.