Tensions Rise Between the US and Iran, But Bond Market Bets on '2022-style Rate Hikes'? UBS: That's Unrealistic

Rising tensions in the Middle East have driven global bond yields higher, leading the market to bet that major central banks may repeat the coordinated rate hikes seen in 2022. However, UBS Group Chief Strategist Bhanu Baweja warns that this logic contains a fundamental misjudgment.

In an interview with Bloomberg TV, Baweja said, "The way the market is pricing things looks like a return to 2022—bundling all central bank actions together. But the current situation is fundamentally different."

He believes that the European Central Bank, the Federal Reserve, and the Bank of England are more likely to respond "asymmetrically" rather than moving in lockstep on rate hikes. In his view, a supply shock in fuel markets is more likely to drag down economic growth, which would actually limit the scope for further central bank tightening.

These comments have direct implications for bond investors. Baweja points out that short-term bonds in the U.S. and the U.K. appear undervalued due to the sharp rise in yields, offering opportunities for contrarian investors to find value.

Market Pricing Replays 2022 Rate Hike Playbook

Since the outbreak of the Middle East conflict in late February, markets have significantly increased expectations for rate hikes by major economies, driving government bond yields steadily higher. Swap market pricing shows that investors have largely priced out expectations of rate cuts by the European Central Bank, Federal Reserve, and Bank of England this year.

European bonds fell on Tuesday, with the short end falling sharply as the money market further bet on tightening. The yield on Germany’s two-year government bond rose 6 basis points to 2.68%, and U.S. bonds weakened across the board.

Baweja believes U.S. and U.K. government bonds are especially mispriced, reflecting expectations that inflationary pressure will force central banks to start a new round of rate hikes similar to 2022. He specifically pointed out: "For the fixed income market, value is emerging at the short end, especially in the U.K. and especially in the U.S."

Fuel Shock Logic Fundamentally Differs from 2022

Baweja emphasizes that this round of energy price shocks differs in its transmission mechanism from what happened in 2022.

The current disruptions in fuel markets are more likely to erode economic momentum rather than simply stoke inflation—meaning central banks face downward pressure on growth, not an overheating in demand that must be tamed with rate hikes.

Against this backdrop, even if inflation data rises in the short term due to higher energy prices, central banks will find it difficult to aggressively tighten policy like in 2022, ignoring risks to growth.

The macroeconomic environments facing the Bank of England and Federal Reserve have structurally changed compared to three years ago, making it unwise to bundle their policy paths together and ignore their unique constraints.

No Matter the Geopolitical Trajectory, Short-Term Bonds Are Attractive

Baweja provides an asymmetric risk-reward framework for his view: regardless of how the situation evolves, the current risk-return for short-term bonds is skewed favorably.

"If the situation resolves smoothly, fixed income—especially in the short end—will perform much better than the loss it would suffer if things deteriorate further," he said.

In other words, if geopolitical risks cool and rate hike expectations subside, short-term yields could face significant downside; while even if tensions persist, the economic strain will in itself limit the actual extent of central bank rate hikes.

Currently, the market remains in a wait-and-see mode, evaluating signals of potential easing in Middle East tensions, while watching Trump’s threat that if a deal is not reached by 8 p.m. Eastern Time on Tuesday, he will escalate strikes on Iran’s infrastructure. This window of uncertainty is precisely why Baweja believes the value of short-term bonds has not yet been fully recognized.