You might think the war in the Middle East and monetary policy decisions by the Federal Reserve wouldn't have much of a connection. You would be wrong.
Fed watchers and futures markets are suddenly pricing in fewer rate cuts in 2026, partly as a result of the economic impact of the ongoing Iran war. Put differently, they're beginning to predict that the Fed's target interest rate -- the short-term federal funds rate, which sets the tone for all other interest rates -- will be higher by the end of 2026.
That's a bad thing for the stock market, as lower borrowing costs are good for corporate profits -- they lower companies' interest costs and make it cheaper to borrow to expand -- and good for consumer spending, as they tend to pull down rates on home loans, car loans, and other consumer loans.
And until the war began, investors were beginning to count on dramatically lower rates by the end of 2026. So what should investors do now?
Futures markets now predict just one quarter-point rate cut this year
Only a month ago the futures market predicted that the most likely interest rate scenario was two quarter-percentage-point cuts by the end of this year, with a rising possibility of a third.
Image source: Getty Images.
That reversed in recent days. Today, the most likely scenario is just one rate cut this year, according to futures traders. And the probability that the Fed doesn't cut rates at all in 2026 has risen over the past week from about 6% to almost 16%.
Why the dramatic change in the rate outlook? It's mostly due to the recent spike in oil prices, the biggest increase in four years. Brent crude, the international benchmark, has risen almost $13 per barrel since the beginning of the conflict, from about $71 a barrel to about $85 on Thursday. West Texas Intermediate oil, the type produced in the U.S., has risen from about $65 a barrel to $80.
The spike in oil prices is due to the fact that the Strait of Hormuz, which is vulnerable to Iran attacks, has essentially come to a standstill in recent days, and some 20% of global petroleum moves through that narrow passage that connects the Persian Gulf with the wider world.
And futures traders aren't the only ones changing their interest rate forecast. This week former Fed Chair Janet Yellen said a possible hit to economic growth from the war and an increase in inflationary pressures -- mostly due to a spike in oil prices -- will likely make the Fed more reluctant to cut interest rates. "I think the recent Iran situation puts the Fed even more on hold, more reluctant to cut rates than they were before this happened," Yellen told a conference on Monday.
The stock market has been counting on lower interest rates this year, so this could be a real headwind for stocks in 2026. As you invest, it is well worth keeping this in mind.
