The Fed Was Supposed to Cut Rates This Year. Now the Market Is Pricing a Hike.

As of Friday morning, traders in the futures market pushed the probability of a rate increase by the end of 2026 to 52%, the first time it has crossed the 50% threshold this year, according to the CME Group FedWatch tool. Twelve months ago, the idea of the Fed hiking rates in 2026 was not even part of the conversation. Today it is the modal outcome in the futures market. That is a seismic shift in monetary policy expectations, and understanding why it happened matters enormously for how you think about every asset class right now.

The simple version is this: the Iran war broke the inflation math.

The Federal Reserve entered 2026 with a relatively clear picture. Inflation was above target but trending in the right direction. The labor market was cooling gradually without cracking. Growth was holding up. The Fed's own Summary of Economic Projections from December 2025 showed the median committee member expecting one cut in 2026, with the path of policy dependent on incoming data continuing to cooperate.

Then the conflict began at the end of February and the Strait of Hormuz, the narrow waterway through which roughly 20% of the world's daily oil supply passes, was effectively closed. Brent crude, which had been trading in the low $70s before the conflict, is now above $108. The OECD revised its US inflation forecast for 2026 up to 4.2%, against a prior projection of 2.8% and the Fed's own estimate of 2.7%. Import prices jumped 1.3% in February, the largest monthly increase since March 2022. Food prices are beginning to respond to a surge in fertilizer costs tied to Middle East supply disruption. The downstream inflation effects of this energy shock are still working their way through the system.

At the same time, the labor market remains stubbornly strong. Initial jobless claims came in at 210,000 this week, just below forecasts and still historically low. Continuing claims hit their lowest level since May 2024. This is not a labor market that is sending distress signals. Which means the Fed cannot use weakness in employment as a justification to ease policy, even as the economy faces a very real energy price shock.

That combination, rising inflation driven by an external supply shock alongside a tight labor market, is the precise configuration the Fed has no good tools to address. Rate hikes can cool demand-driven inflation. They cannot reopen a shipping lane.

For the first time since the 1970s, serious economists are using the word stagflation in a context that is not purely academic.

Yardeni Research raised the probability of a 1970s-style stagflation scenario to 35%, up from 20% earlier in the year. The Apollo Chief Economist has noted that the Fed's own forecasts now embed the possibility of rising inflation and rising unemployment simultaneously, the definitional condition of stagflation. Even Fed Chair Jerome Powell, who notably called stagflation "a 1970s term" at his last press conference, acknowledged the bank is in "a difficult situation" trying to balance the two sides of its dual mandate.

The parallel to the 1970s is not perfect. US domestic energy production has buffered some of the immediate shock in a way that was not available fifty years ago. Strategic petroleum reserve releases have been announced. The OPEC-plus group added output. But none of these mechanisms can replace the approximately 20 million barrels per day that normally passes through the Strait of Hormuz, and there is no realistic short-term substitute for that volume.

The 10-year Treasury yield is now at 4.4%, near its highest level since July of last year, rising steadily over the past week as energy prices push inflation expectations higher and reduce confidence that the Fed can cut. Bonds are pricing in less easing. Equities are pricing in margin compression from higher input costs and borrowing rates. The two assets that are supposed to provide diversification are falling together, which is historically the signature of a stagflationary regime rather than a standard recessionary or inflationary one.

The Federal Reserve's choices right now are genuinely constrained in a way that goes beyond normal monetary policy uncertainty.

If the Fed hikes, it risks crushing a labor market and a broader economy that is already under stress from the energy shock. Consumer sentiment fell to 53.3 in the final March reading from the University of Michigan, down nearly 7% from a year ago. One-year inflation expectations rose to 3.8%. Consumers are already feeling the pressure. A rate hike into that environment risks turning an energy-driven slowdown into a genuine recession.

If the Fed cuts, it risks validating inflation expectations at a time when the OECD is projecting 4.2% inflation and oil is above $100. Cutting into a supply shock would almost certainly be interpreted by markets as a policy error, potentially unmooring the inflation expectations that the Fed spent the better part of three years re-anchoring after the post-COVID inflation surge.

If the Fed holds, it threads a narrow needle between both risks but provides no relief to an economy being squeezed simultaneously from two directions. This is the likely path for the April 28-29 FOMC meeting, with market implied odds heavily favoring no change in the near term.

Adding complexity to an already complicated picture is the leadership transition at the Fed. Chair Jerome Powell's term expires in May 2026, and President Trump nominated Kevin Warsh to succeed him. Senator Elizabeth Warren has already sent a pointed letter to Warsh citing concerns about his track record during the 2008 financial crisis. A confirmation process playing out against a backdrop of oil shocks, stagflation risk, and market stress is not a recipe for institutional clarity at the institution that markets depend on most for macroeconomic stability.

The shift in rate expectations from two cuts to a potential hike is not an abstract policy question. It has direct portfolio implications that are worth thinking through clearly.

Equities get hit from multiple directions in a rising-rate, rising-inflation environment. Higher discount rates compress valuations on long-duration growth stocks. Higher energy and input costs compress margins across the economy. Reduced consumer purchasing power, as gasoline at $8 per gallon in some US cities is already demonstrating, pulls revenue from discretionary sectors. The equity risk premium, already thin given where valuations sat at the start of 2026, has no buffer for all three of these forces arriving simultaneously.

Fixed income is equally complicated. Short-duration bonds hold up better than long duration when the yield curve is steepening on inflation fears. TIPS, which are indexed to inflation, provide direct protection against the scenario currently unfolding. Cash, yielding above 3.5% at the current federal funds rate, offers real return for the first time in years and provides optionality in an environment where future asset prices are difficult to model.

The sectors with structural tailwinds in this environment are the same ones that have been working since the conflict began: energy producers, defense contractors, and commodity-linked equities. These are not attractive because the geopolitical situation is good. They are attractive because the geopolitical situation is not going away quickly, and the cash flows of companies in those sectors improve directly as the crisis extends.

The broader macro picture that investors thought they were managing at the start of 2026, moderate growth, declining inflation, two rate cuts, benign volatility, no longer exists. The economy that exists now has $108 oil, 4.2% projected inflation, a Fed that may hike rather than cut, and a geopolitical variable that has defied every prediction and diplomatic proposal thrown at it for four weeks.

That is the macro environment you are investing in. Price it accordingly.