We’re witnessing a turn in the interest rate cycle. Be prepared for rate hikes.

• The recent US-Iran conflict has raised inflation risks and disrupted the prior rate-cut narrative.
• This oil shock comes amidst ongoing inflationary pressures driven by tariffs and fiscal stimulus in the US, and could amplify said pressures.
• Investors should prepare for global rate hikes, which could intensify if the conflict drags out.
• The extent of hikes will differ between central banks. The Fed faces a higher bar to hiking (though cuts are out of the question), while the ECB and BOE look extremely likely to hike.
• We prefer short- to medium-tenor USD bonds for their decent yields without too much duration risks.

In the past year, the dominant market narrative was straightforward: growth would remain decent, inflation would continue grinding lower, and central banks (including the Fed) would continue cutting rates. In our yearly Outlook piece, we did not rule out the possibility of further rate cuts in 2026, although we expected the pace of easing to be moderate, especially in markets where inflation remained persistently above target.

The latest Middle East conflict has unsettled that narrative. Oil prices have surged, bond yields have risen sharply, and the balance of risks has shifted materially. As such, we are updating our interest rates stance. Falling policy rates are no longer the only credible base case; investors should now seriously consider the possibility of rate hikes across major central banks.

Lessons from previous US energy-driven inflation shocks

History offers several examples of energy-driven inflation shocks in the US. Since 1970, notable episodes when headline CPI energy inflation rose above 25% y/y include 1974 (34%), 1979 (47%), and 2022 (42%) (Chart 1). During such periods, energy typically accounted for 6% to 12% of the CPI basket, excluding second-order effects that fed into non-energy inflation components. Overall, large moves in energy prices can still contribute meaningfully to headline inflation despite a relatively small direct weight.

At the time of writing, WTI crude futures have jumped over +50% month-to-date (MTD) to $100/bbl. Similarly, retail prices for gas (from AAA-compiled national averages) and diesel (from EIA weekly on-highway diesel prices) have risen by +33% and +41% MTD, respectively (Chart 2). Without complex modelling, it does not seem far-fetched to assume that energy could contribute 1 percentage point (pp) to overall CPI inflation, pushing it back toward 4%.

Importantly, some past oil shocks hit when other inflationary pressures were already in play pre-shock (Chart 3). This suggests that energy shocks can amplify pre-existing inflationary pressures, which matters as the US is again entering an oil shock with inflation above target.

Chart 1: Periods of high energy-driven inflation across history

Chart 2: Energy prices have risen significantly since the conflict started

Chart 3: Energy inflation may amplify already-existing inflationary pressures

What about inflation today?

Today’s backdrop is not identical to past episodes, but there are enough similarities to warrant caution. For instance, supply-chain disruptions are less severe than in 2022, and energy’s share of CPI today (6%) is below that in 1979 (10%). However, the key similarity is the presence of pre-existing inflationary pressures, including from tariffs and/or fiscal stimulus (e.g. OBBBA in 2025). Powell recently stressed that US inflation has remained above the Fed’s 2% target for more than 5 years, underscoring the persistence of underlying inflation.

Meanwhile, the US-Iran war remains fluid with no clear signs of a resolution. There is uncertainty on whether a deal can be reached; even if a ceasefire or peace deal is reached, it may initially prove fragile. Oil prices may remain elevated as markets continue to price in geopolitical risks, while shipping tariffs imposed by Iran could add further upward pressure. Furthermore, oil supply is unlikely to normalise immediately, especially if infrastructure has been damaged, which could prolong inflationary pressures. Taking these factors together, we believe oil prices could remain above pre-war levels for a while.

The recent oil shock, therefore, presents meaningful upside risks to the US inflation outlook. Long-term inflation expectations still appear reasonably well anchored, with 5y5y inflation swaps and 10-year breakevens around 2.3%. However, short-term inflation expectations have jumped since the war started, with 1-year breakevens rising from 3.8% to 5.2%, and 2-year breakevens from 2.7% to 3.3% (Chart 4). The Fed will be watching closely to ensure that long-term expectations do not begin to move higher as well.

Chart 4: Short-term inflation expectations have jumped, but long-term expectations remain better anchored

Why global rate hikes may be coming

US Federal Reserve

Looking ahead, we do not expect rate cuts from the Fed. We also see room for rate hikes if inflation surges upward, and the conflict lasts for a prolonged period. This marks a change from our previous stance, when we remained open to the possibility of gradual rate cuts by the Fed.

First, Powell has made clear that he is now less inclined to ‘look through’ inflation shocks after many years of above-target inflation. In the US, both CPI and PCE inflation remain above 2%, while the latest Fed PCE projections have shifted higher and show greater dispersion. Ongoing inflationary pressures from tariffs and fiscal stimulus, combined with second-order effects from the oil shock, further threaten the outlook.

Our rates view is based on the expectation that the Fed will focus more on the inflation side of its dual mandate than on the labour market. The labour market may appear soft, but it shows no signs of a collapse at this point. Inflation, by contrast, appears more vulnerable to significantly renewed upside risks from oil, tariffs, and other factors. Faced with such asymmetric risks, we think the Fed will see greater danger in easing too early and reigniting inflation than in tolerating more cooling in the labour market.

In addition, Fed independence remains intact despite political pressure to cut rates – the Fed will continue responding primarily to macroeconomic fundamentals, especially inflation. Powell has indicated he will remain as Chairman until Warsh (Trump’s nominee) is confirmed. Even Miran, a Trump appointee and one of the most dovish voices within the Fed, has revised his 2026 rate forecasts higher.

We also acknowledge that the US is a net exporter of oil, which gives it more energy security than net importers (Chart 5). Even so, US consumers are not fully insulated when global oil benchmarks rise sharply, as the recent jump in retail gasoline prices already shows. A net-exporter status helps but does not fully shield the US from energy-driven inflation shocks.

Chart 5: US is a net exporter of oil (negative net imports = net exporter)

Other central banks (mainly ECB & BOE) – more vulnerable

The case is different for Europe and the UK, where rate hikes look far more likely now. This also marks a sharp change from before, when markets were pricing in rate holds or even cuts by the ECB and BOE respectively.

First, Europe and the UK are more vulnerable because they are net importers of energy. Recent ECB and BOE meetings illustrated this, with policymakers revising up inflation forecasts and adopting a clearly more hawkish tone. Markets have also sharply repriced their rate expectations and are now pricing in 2 – 3 hikes this year (Chart 6).

Between the two, we believe Europe is more vulnerable to hikes. The EU estimates that over 50% of its energy demand was imported, while over 10% of its total imports include energy-related products (Table 1). Pre-war macroeconomic conditions also looked somewhat firmer in Europe, with 4Q GDP growth of 2.6% (UK: 1.0%), while unemployment had been gradually trending down from the COVID era (Feb: 6.1%). Meanwhile, real yields (proxied by German sovereign yields less EU inflation) remain low, suggesting the ECB may have room to raise rates without choking off growth.

For the UK, we think hikes are likely coming too, though the situation is less clear-cut. The UK economy entered the shock with a weaker 4Q GDP growth of 1.0% and clearer signs of increasing labour market slack. While fuel imports account for a slightly lower percentage of total imports compared to the EU, it remains vulnerable to higher energy prices (Chart 7). Coupled with a higher starting policy rate, this suggests the BOE may still hike, thought he pace will depend on how macroeconomic conditions evolve.

For other markets, policy responses will depend on country-specific factors. This includes the degree of reliance on energy imports, the composition of those imports (e.g. oil vs natural gas vs coal), the weight of energy in CPI, and the broader pre-war macroeconomic and inflation backdrop. For instance, the RBA has already hiked rates twice this year – once before the war, and once after the war started. Overall, while reaction functions will differ, we think it is increasingly clear that global central banks will turn more hawkish this year (Chart 8).

Chart 6: Market expectations are now pointing toward rate hikes by ECB and BOE

Table 1: EU is heavily reliant on imports for its energy consumption

Chart 7: UK is still vulnerable to imported inflation when fuel prices increase

Chart 8: Markets are already shifting toward global rate hikes

Continue monitoring the Middle East conflict

Our belief that the global rates cycle is turning is primarily centred on a resurgence of inflation driven by higher energy prices.

There is still a positive scenario, but it requires several things to go right. First, there would need to be a rapid de-escalation of this conflict. The de-escalation would also need to prove credible and durable, likely requiring at least a few months, and lead to a full reopening of the Strait of Hormuz. Oil production would then need to resume quickly, while repairs of damaged infrastructure would also have to proceed faster than expected. Even then, oil prices would likely take time to normalise. Oil futures still point to market expectations of a higher-for-longer oil price environment, suggesting that this benign outcome remains unlikely for now (Chart 9).

We emphasise that this scenario requires several events to line up neatly and would still take time to achieve. Recent unilateral announcements by either the US or Iran have failed to calm oil markets for a sustained period (despite short-term volatility), suggesting that uncertainty remains high.

Amidst significant uncertainty over the duration and extent of the war, and the resultant energy disruptions, it is clear to us that upside risks to inflation have increased, and this would generally push global rates higher. That said, the uncertainty over the duration and intensity of this conflict makes it difficult to forecast a single outcome. There will also be some divergence in central bank moves this year, with the Fed having a higher bar to hike rates versus the ECB or BOE.

Chart 9: Oil futures point toward market expectations of higher-for-longer prices

Final thoughts and recommendations

We are witnessing a turn in the interest rate cycle. While news headlines have moved away from a rate-cut narrative, we think it is important to stress a meaningful possibility of global rate hikes in 2026. As noted, this will vary by country, with the US Fed perhaps more resistant to hikes than its peers in the ECB and BOE.

For the USD bond space, we prefer short to medium-tenor bonds.

1. Short-term bonds: We favour these because of their low sensitivity to interest rates. Yields also remain decent in the high-3% range for USTs, and the yield story has actually improved now that rate cuts look less likely in 2026.
2. Medium-term bonds: As we stressed in previous articles, selectivity remains key. These bonds still offer a decent yield pickup over shorter-tenor bonds, and that pickup has improved following the recent bear steepening. Nonetheless, investors should be mindful of adding on too much duration at one go, and should be prepared for greater price and yield fluctuations in this uncertain environment.
3. Long-term bonds: These are more vulnerable, especially if rate hikes materialise, and/or long-term inflation expectations start to re-price higher. There may still be tactical opportunities, but investors should have a clear entry and exit plan in mind before investing.

More broadly, strong fundamentals and balance sheets remain key to investing in a period of multiple uncertainties. This is partly because of the war, but also because of pre-war factors like AI disruption and macroeconomic uncertainties. We are also turning less positive on EM debt, given (i) rising inflationary risks across major emerging markets; (ii) a greater likelihood that EM policy rates stay on hold or move higher; while (iii) EM bond spreads remain at the tighter by historical standards. We will look to publish a comprehensive update in the coming weeks detailing our full rationale.

Table 2: Fund recommendations (shorter-duration options bolded)

Declaration: For specific disclosure, at the time of publication of this report, IFPL (via its connected and associated entities) and the analyst who produced this report hold NIL positions in the abovementioned securities. This research report was prepared with the assistance of artificial intelligence (AI) tools. iFAST Financial Pte Ltd does not rely exclusively on AI for content generation; the content of this report – including all investment theses, ratings, price targets and conclusions – has been independently reviewed and verified by the research analyst(s) to ensure accuracy and professional integrity.