by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM ET] | PDF

Our Comment opens with the latest escalation in the Iran conflict. We then turn to the Federal Reserve, examining the growing speculation of a potential rate hike at this meeting. Next, we briefly cover Ukraine’s drone campaign inside Russia, the US crackdown on imports of Chinese-made robots, and China’s deepening involvement in the Iran conflict. As always, we also include a review of recent domestic and international economic data.

Surprise Attack: Tensions between the United States and Iran are likely to intensify following reported attacks on US military bases. On Tuesday, US officials said ballistic missiles targeting American bases in the Middle East were successfully intercepted, with no reported damage. Still, the incident has renewed apprehension that the fragile de-escalation between the two sides could quickly unravel. The attacks also raise the risk that the conflict could reaccelerate and broaden beyond its current scope.

• The timing coincides with growing signs that the conflict is spreading across the Middle East. On Tuesday, an Iran-backed militia in Iraq launched a drone attack targeting oil fields in Saudi Arabia, marking an apparent expansion of strikes that began Monday across multiple locations, including Kuwait and the United Arab Emirates. The pattern of attacks suggests a broader Iranian effort to deter regional actors from supporting US military operations.
• The attacks are likely to complicate efforts to wind down the conflict. Prior to the reports, President Trump met with Israeli Prime Minister Benjamin Netanyahu and indicated that the United States may be reluctant to deepen its involvement. At the same time, Trump struck an optimistic tone on negotiations, stating that talks with Iran were progressing well, while reiterating his threat to target Iranian infrastructure if a deal is not reached.
• The recent escalation underscores how this war may not have a clear off-ramp. Iran’s attacks indicate it is prepared to prolong the conflict so long as it believes that doing so preserves leverage in negotiations. The US, meanwhile, is left with a difficult choice between widening a highly unpredictable conflict or adopting a more restrained approach that acknowledges the limits of its willingness to defend maritime interests in the region.
• While the US may prefer to de-escalate, the continuation of the conflict could well keep it involved. US forces may ultimately be pressed to take more aggressive steps to reassert deterrence, including the potential deployment of troops and broader operations in Iran. This uncertainty is expected to support energy prices and weigh on bond markets going forward. Equities, however, may remain relatively resilient as investors stay more focused on earnings.

Fed Talks: There is growing speculation that the Federal Reserve may hike rates following today’s meeting. According to Citadel Securities, new Fed Chair Kevin Warsh may look to surprise markets with a rate hike as a way to strengthen his inflation-fighting credentials. The move would coincide with growing unease about inflation, as the conflict in the Middle East continues to rattle energy markets. While markets still favor a pause, the potential for a surprise hike could shock markets.

• Speculation about the Fed’s next move has intensified as markets try to assess how the central bank will preserve credibility amid uncertainty in the Middle East. The resurgence in fighting between the US and Iran has pushed oil prices higher again, with crude approaching $100 a barrel last week. More broadly, renewed tariffs have raised questions about the ability of firms to manage cost pressures, adding to concerns about whether businesses will pass those costs on to consumers.
• Additionally, there has been a notable hawkish shift within the FOMC. In the latest dots plot, a majority of committee members favored either keeping rates unchanged or raising them this year, with only one participant, most likely Fed Governor Michelle Bowman, expecting a rate cut. This marks a sharp departure from the previous dots plot, released at the onset of the Iran conflict, when the majority favored rate cuts and none anticipated a hike.
• The push for more hawkish policy comes as markets begin to question the Fed’s willingness to address rising inflation pressures. The 10-year yield has risen by as much as 30 basis points since the last FOMC meeting, suggesting that inflation premia have begun to increase. That move comes as investors appear to be losing confidence in the Fed’s ability to use its policy tools to bring inflation back down. As a result, a rate hike could help restore some of that confidence.
• Although a rate hike at today’s meeting is not our base case, we think it remains possible given Warsh’s desire to restore the Fed’s credibility. In our view, any rate hike would probably be described as a one-off move, as the central bank seeks to keep its options open for the next few meetings. While the prospect of a rate hike would probably weigh on equities, it may offer some relief for long-term bond yields.

Ukraine Expands: Kyiv has intensified its campaign against Russian energy infrastructure, broadening its focus beyond oil refineries to other hard-to-replace critical assets. The shift comes as Ukraine’s long-range strikes have grown more effective, and as Kyiv seeks to raise the economic cost of the war and pressure Moscow back to the negotiating table. By targeting infrastructure that is difficult and slow to rebuild, Ukraine aims to compound the financial and logistical strain on Russia’s war effort.

AI Protectionism: The White House has announced a ban on Chinese-made humanoid robots over national security concerns. The decision to restrict the use of Chinese robots comes as the US seeks to prevent Chinese technology from being embedded in its supply chains. The move also reflects China’s growing role as a market leader in AI-powered robotics. It could pave the way for additional measures as Washington looks to maintain its edge over China in the AI race.

China Backing Iran? Iran is expected to receive a shipment of Chinese-made air defense missile launchers in the coming weeks. The move comes as Iran seeks to strengthen its air defenses in preparation for a potentially prolonged conflict with the US. Chinese involvement is apt to heighten concerns amid rising tensions between Washington and Beijing. The shipment also underscores Beijing’s support for rivals of the US and could further strain relations between the two powers.

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