European sovereign bonds face “a perfect storm” after fresh inflation fears triggered by the Iran conflict forced the region’s central banks to signal a new direction for interest rates on Thursday, sending yields higher.
The Bank of England left interest rates unchanged at 3.75% on Thursday, while the European Central Bank also remains stable on borrowing costs, as the economic impact of soaring energy costs weighs on policymakers.
Yields on Gilts at 10 years oldthe benchmark for UK 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 generally more sensitive to rate decisions, immediately jumped 39 basis points, the biggest rise since former Prime Minister Liz Truss’s “mini-budget” in September 2022. They were last seen up 27 basis points, at 4.378%.
French, German and Italian bonds faced less selling pressure, but yields rose across the continent.
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British gilts at 10 years old.
Market strategists say the BoE’s decision – a unanimous call from its nine-member monetary policy committee – effectively ends hopes of further rate cuts this year and significantly changes the policy outlook from what it was just two weeks ago.
Tactical TradingEd Hutchings, head of rates at Aviva Investors, said the chances of a BoE rate hike in the coming months have increased.
“Bearing this in mind, from an asset allocation perspective, we could start to see investors tactically add overweights to gilts in the near term, with at least one rise expected later in the year from today,” Hutchings said.
Matthew Amis, investment director, rates management at Aberdeen Investments, described the current environment as a “perfect storm” for European sovereign bond markets.
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German bunds at 10 years.
“Rising energy prices and the Bank of England opening the door to possible rate hikes have seen government bonds soar. German Bunds are relatively calm in this storm but still pushing 3% due to similar inflation fears,” Amis told CNBC via email.
“Gilts and Bunds are embedding a much longer conflict than other markets, focusing on the surge in inflation while markets are not yet focused on the potential negative impact on growth.”
At the same time, the ECB’s next move is likely to be a hike, according to Simon Dangoor, deputy chief investment officer for fixed income and head of macro bond strategies at Goldman Sachs Asset Management.
“The governing council is clearly sensitive to the risks of rising inflation, but it will likely seek to assess potential second-round effects before making a decision,” Dangoor said. “An increase is therefore possible later in 2026; however, the ECB stands ready to act sooner if the situation deteriorates.”
“An economical Dunkirk”Energy prices continued to rise on Thursday, with Brent crude, the international benchmark, reaching $111.10, up 3.5%, while natural gas prices also rose.
Europe has sought to diversify its energy mix after the 2022 price shock caused by Russia’s invasion of Ukraine. But the continent remains a net importer of oil and gas.
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Brent crude.
“Yields are waking up to the economic Dunkirk that the global economy is facing thanks to the Iran war,” Chris Beauchamp, chief market analyst at IG, told CNBC via email. “Investors will demand higher borrowing costs from European countries as the outlook darkens. And that’s just for Brent at $110.”
Looking ahead, Amis said if a real easing of tensions happens soon, government bond markets could start to look attractive. In this case, expectations of rate hikes, now priced for the remainder of 2026, could quickly reverse.
“However, for now, with no apparent end in sight and central bankers dusting off the ‘things we did wrong in 2022’, European sovereign markets will remain volatile,” Amis added.
But Nicholas Brooks, head of economic and investment research at ICG, said Thursday’s rise in yields could prove short-lived. He said oil would need to stay above $100 for an extended period before the ECB considered a hike, and suggested the central bank would likely maintain its benchmark rate.
“Even though sustained increases in energy prices will likely delay rate cuts from the Fed and BoE, we believe that by the second half of the year both central banks will have the opportunity to cut rates,” Brooks told CNBC via email.
“While there is considerable uncertainty about the outlook, our base case remains that energy prices will fall in the coming weeks and months and government bond yields will fall from current levels,” he added.
