Bond markets face ‘perfect storm’ as Iran war rattles central banks

Europe’s sovereign bonds are facing a “perfect storm” after fresh inflation fears sparked by the Iran conflict forced the region’s central banks to signal a new course for interest rates on Thursday, sending yields down.

The Bank of England left interest rates unchanged at 3.75% on Thursday, with the European Central Bank also holding borrowing costs steady as the economic impact of rising energy costs hangs over rate-setters.

yields above 10-year giltsThe benchmark for UK government debt rose more than 13 basis points to 4.871% – a new 52-week high on Thursday – before easing. Yields on 2-year gilts, which are usually highly sensitive to rates decisions, immediately jumped 39 basis points in September 2022 in the biggest rise since former prime minister Liz Truss’ ‘mini budget’. They last saw 27 basis points higher at 4.378%.

French, German and Italian bonds saw less intense selling pressure, while yields rose across the continent.

Market strategists say the BoE’s move – a unanimous call from its nine-member monetary policy committee – effectively ends hopes of any further rate cuts this year and dramatically changes the policy outlook from just two weeks ago.

Ed Hutchings, head of investor rates at Aviva, said the chances of a rate hike from the BoE in the coming months were high.

“With this in mind, from an asset allocation perspective, we can see investors strategically adding more weight to gilts in the short term, expecting at least one increase later in the year from now,” Hutchings said.

Matthew Amis, investment director, rates management at Aberdeen Investments, described the unfolding environment as a “perfect storm” for Europe’s sovereign bond markets.

“Energy prices rising and the Bank of England opening the door to a potential rate hike saw gilts higher. German bunds have been relatively calm in this storm but are still pushing 3% on similar inflation fears,” Amis told CNBC by email.

“Gilts and bunds are pricing in a more prolonged conflict than other markets, with markets focusing on a surge in inflation still focusing on the potential negative impact on growth.”

Meanwhile, according to Simon Dangoor, Deputy Chief Investment Officer of Fixed Income and Head of Fixed Income Macro Strategies at Goldman Sachs Asset Management, the ECB’s next move will now be a hike.

“The Governing Council is clearly sensitive to upside inflation risks, but may look to assess potential second-round effects before making a move,” Dangur said. “A hike in 2026 is therefore possible; however, the ECB stands ready to act sooner if the situation worsens.”

Energy prices continued their upward advance on Thursday, with Brent crude, the international benchmark, hitting $111.10, up 3.5%, while natural gas prices also traded higher.

Europe has sought to diversify its energy mix following the 2022 price shock caused by Russia’s invasion of Ukraine. But the continent remains a net importer of both oil and gas.

“Yields are waking up to the economic Dunkirk the global economy is facing due to the war in Iran,” Chris Beauchamp, chief market analyst at IG, told CNBC via email. “Investors want higher borrowing costs from countries across Europe. The outlook is getting darker. And it’s just $110 with Brent.”

Looking ahead, if a real easing of tensions occurs soon, government bond markets could start to look attractive, Amis said. In that case, rate hike expectations could quickly reverse now for the rest of 2026.

“However, for now, with no clear end in sight and central bankers dusting off the ‘mistakes we made in 2022’ playbook, European sovereign markets will remain a volatile place,” added Amis.

But Nicholas Brooks, head of financial and investment research at ICG, said Thursday’s yield spike could prove short-lived. He said oil would need to stay above $100 for an extended period before the ECB would consider hiking, and suggested the central bank may hold its benchmark rate.

“While sustained high energy prices will delay Fed and BoE rate cuts, we think that by the second half of the year, both central banks will have room to cut rates,” Brooks told CNBC via email.

“While there is considerable uncertainty about the outlook, energy prices will continue to decline in the coming weeks and months and government bond yields will fall from current levels,” he said.