Executive Summary
War‑related disruptions and a fragile peace deal with Iran are embedding a new layer of inflation into the U.S. outlook, even as headline price growth had been moderating. From December 2024 to December 2025, CPI rose 2.7%, and annual inflation picked up again to 3.3% by March 2026, the highest level since May 2024. Markets initially marked up the expected policy rate at the end of 2026 by almost 75 basis points after the conflict, but that premium has since narrowed to about 50 basis points—still a clear signal that investors see higher inflation ahead and at least some Fed response.
War, Peace and an Inflation Floor
The economic dividend of peace with Iran looks inflationary, not disinflationary. Energy-sensitive components of CPI have already reaccelerated, with U.S. headline inflation running at 3.3% in the 12 months to March 2026 and energy prices up more than 12% over the year. That comes on the heels of a 3% CPI increase from January 2024 to January 2025 and a 2.7% gain from December 2024 to December 2025, suggesting the easy phase of disinflation is over.
Markets have responded by revising the expected policy rate path. The net change in 2026 rate expectations peaked at nearly 75 basis points in late March, meaning investors briefly assumed the fed funds rate at end of 2026 would be three‑quarters of a percentage point higher than before the war, before easing back to about 50 basis points today. That stickiness reflects a judgment that war‑induced inflation is coming through, and the Federal Reserve will not completely ignore it.
Real Rates Under Pressure
So far, real yields have held in positive territory. The 10‑year TIPS yield is about 2% to 2.1%, up modestly over the past year, while CPI is running in the low‑3s, implying a real policy backdrop that is only slightly restrictive. In mid‑2025, the real rate on the 10‑year Treasury, nominal yield minus trailing CPI, was about 2.2%, but that buffer has been narrowing as inflation firms and the Fed talks more about cuts than hikes.
Expected real rates have slipped across the curve over the past year and now sit just above zero, consistent with market pricing for only limited Fed tightening relative to the jump in expected CPI. Derivatives and forwards imply the funds rate drifting down to roughly the low‑3s by late 2026, even as inflation expectations push break‑evens toward the mid‑2s. In other words, the market assumes the Fed will do just enough to offset the inflation impulse but no more.
If that view shifts, if investors conclude that the Fed will prioritize its employment mandate and political constraints and reverse the modest hikes still priced in, expected real rates will mechanically fall into negative territory. With higher CPI effectively “baked in” by recent energy and goods prints, a dovish Fed path would guarantee a drop in real rates, raising the odds of second‑round effects in wages and services.
In that scenario, real rates are no longer a safety valve; they become the channel through which today’s war‑driven inflation morphs into tomorrow’s entrenched price regime.
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- Why the U.S. 10-Year Yield Keeps Snapping Back to “Neutral”
- U.S. Treasuries Still “Safe” But No Longer Truly Risk-Free
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