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

Europe’s sovereign bonds are facing “a perfect storm” after new 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 soaring.

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

Yields on 10-Year Gilts, the benchmark for U.K. government debt, rose more than 13 basis points to 4.871% — a new 52-week high on Thursday — before easing.  The yield on 2-Year Gilts, which are typically more sensitive to rates decisions, immediately surged 39 basis points in the biggest rise since former Prime Minister Liz Truss’s ‘Mini Budget’ in September 2022.  They were last seen 27 basis points higher, at 4.378%.

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

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

Ed Hutchings, head of rates at Aviva Investors, said that the chances of a rate hike from the BoE over the coming months have increased.

“With this in mind, from an asset allocation perspective, we could start to see investors tactically adding overweights in gilts in the short-term, with at least one hike expected later in the year as of today,” 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 spiking higher and the Bank of England opening the door to potential rate hikes have seen gilts spike higher. German bunds are the relative calm in this storm but are still pushing 3% due to similar inflation fears,” Amis told CNBC via email.

“Gilts and bunds are pricing in a much longer conflict than other markets, focusing on the inflation surge with markets yet to focus on the potential negative impact on growth.”

Meanwhile, the ECB’s next move will now likely be a hike, according to Simon Dangoor, deputy chief investment officer of fixed income and head of fixed income macro strategies at Goldman Sachs Asset Management.

“The governing council is clearly sensitive to upside inflation risks, but will likely look to assess potential second-round effects before making a move,” Dangoor said. “A hike is therefore possible later in 2026; however, the ECB stands ready to act sooner if the situation deteriorates.”

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

Europe has sought to diversify its energy mix following 2022’s 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 that faces the global economy thanks to the war in Iran,” said Chris Beauchamp, chief market analyst at IG, told CNBC via email. “Investors will demand higher borrowing costs from countries throughout Europe as the outlook darkens. And this is just with Brent at $110.”

Looking ahead, Amis said that if a genuine easing of tensions happens soon, government bond markets could start to look attractive. In that case, expectations of rate hikes that are now being priced in for the rest of 2026 could quickly reverse.

“However, for now, with no apparent end in sight and central bankers dusting down the ‘things we did wrong in 2022’ playbook, European sovereign markets will remain a volatile place,” Amis added.

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

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

“While there is considerable uncertainty about the outlook, our base case remains that energy prices subside in the coming weeks and months and that government bond yields will fall from current levels,” he added.