Europe’s government bonds are encountering “a perfect storm” as fresh inflation anxieties ignited by the Iran situation compelled the region’s central banks to indicate a new trajectory for interest rates on Thursday, resulting in a surge in yields.
The Bank of England held interest rates steady at 3.75% on Thursday, with the European Central Bank also maintaining borrowing rates, as the economic ramifications of escalating energy prices loom over rate-setters.
Yields on 10-Year Gilts, the standard for U.K. government debt, increased by over 13 basis points to 4.871% — a record 52-week high on Thursday — before retracting. The yield on 2-Year Gilts, which generally react more to rates decisions, surged 39 basis points immediately, marking the largest jump since former Prime Minister Liz Truss’s ‘Mini Budget’ in September 2022. They were last observed 27 basis points higher, at 4.378%.
French, German, and Italian bonds experienced less intense selling pressure, yet yields climbed throughout the continent.
Market strategists indicate that the BoE’s decision — a unanimous resolution from its nine-member monetary policy committee — effectively eliminates any prospects of further rate cuts this year and significantly alters the policy outlook compared to just two weeks ago.
Tactical trading
Ed Hutchings, head of rates at Aviva Investors, stated that the likelihood of a rate increase from the BoE in the upcoming months has risen.
“Considering this, from an asset allocation standpoint, we may begin to see investors tactically increasing their positions in gilts in the short term, with at least one rate hike anticipated later in the year as of now,” Hutchings remarked.
Matthew Amis, investment director focused on rates management at Aberdeen Investments, characterized the current landscape as a “perfect storm” for Europe’s sovereign bond markets.
“With energy prices surging and the Bank of England hinting at possible rate increases, gilts have surged. German bunds remain relatively stable amidst this turmoil but are still nearing 3% due to comparable inflation concerns,” Amis told CNBC via email.
“Gilts and bunds are reflecting a much longer conflict than other markets, concentrating on the inflation increase while markets have yet to consider the potential adverse effects on growth.”
Moreover, the ECB’s forthcoming action will likely be a rate increase, 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 evidently aware of upward inflation risks, but will probably evaluate potential second-round effects before proceeding,” Dangoor stated. “A hike is thus feasible later in 2026; however, the ECB is prepared to act sooner if conditions worsen.”
‘An economic Dunkirk’
Energy costs continued their upward trend on Thursday, with Brent crude, the global benchmark, reaching $111.10, a 3.5% increase, while natural gas prices also rose.
Europe has attempted to diversify its energy sources following the price shock of 2022 inflicted by Russia’s invasion of Ukraine. Nonetheless, the continent still remains a net importer of both oil and gas.
“Yields are awakening to the economic Dunkirk that confronts the global economy due to the Iran conflict,” stated Chris Beauchamp, chief market analyst at IG, in a message to CNBC. “Investors will demand higher borrowing costs from nations across Europe as the outlook deteriorates. And this is merely with Brent at $110.”
Looking ahead, Amis indicated that if genuine de-escalation occurs soon, government bond markets could begin to appear appealing. In such a scenario, the anticipated rate hikes currently priced in for the remainder of 2026 could swiftly be undone.
“However, for the time being, with no clear resolution in sight and central bankers revisiting the ‘mistakes made in 2022’ playbook, European sovereign markets will remain turbulent,” Amis added.
Nonetheless, Nicholas Brooks, head of economic and investment research at ICG, remarked that Thursday’s yield spike could be temporary. He mentioned that oil prices would need to stay above $100 for a prolonged period before the ECB would contemplate a rate increase, and he suggested that the central bank would likely maintain its benchmark rate.
“While persistently high energy prices will more than likely delay rate cuts from the Fed and BoE, we believe that by the latter half of the year, both central banks will have the capacity to lower rates,” Brooks told CNBC via email.
“Despite significant uncertainty surrounding the outlook, our primary expectation is that energy prices will decline in the coming weeks and months, leading government bond yields to decrease from their current levels,” he concluded.
