Global Bond Markets in Turmoil: Iran Escalation Sparks Rate Hike Concerns

After major central banks worldwide expressed concerns that soaring oil prices could trigger a new round of inflation, global bond markets plummeted across the board. As the Iran conflict disrupts the global economic outlook, markets are experiencing intense re-pricing.

Short-term bonds led the decline, with investors betting that European central banks will have to raise interest rates, while the Federal Reserve is expected to keep rates unchanged for the rest of this year.

This pushed the yield on the two-year U.S. Treasury to an intraday high of 3.95%, up 18 basis points on Thursday morning, before narrowing to about 4 basis points.

European markets fell even more sharply, as disruptions in Middle Eastern supply caused energy prices to jump, likely dealing a heavy blow to the European economy. The Bank of England’s new policy guidance prompted traders to forecast three 25-basis-point rate hikes this year, with the two-year UK bond yield soaring over 28 basis points to 4.38%. The same maturity German government bond yield rose 8 basis points.

“Previously, the consensus was that all of this would end relatively quickly,” said Brij Khurana, a fund manager at Wellington Management. “Now the market is finally starting to fear that the war could last much longer.”

The market’s downturn highlights the dramatic change in the global economic outlook since the U.S. launched its war against Iran at the end of last month. Less than three weeks ago, traders still expected the Federal Reserve to cut rates twice this year, and the Bank of England was anticipated to cut rates at today’s meeting to support a weak labor market.

However, the Middle East conflict and its disruption to global energy and trade shattered those expectations, with no signs of a quick end to the fighting. On Thursday, oil and natural gas prices surged further as escalating attacks in the Persian Gulf region posed a long-term threat to key energy facilities.

Statements from central bank officials this week indicate that, despite the threat of rising oil prices to economic growth, their primary focus remains on inflation risks.

Although the European Central Bank kept rates unchanged at its sixth meeting, traders still expect at least two rate hikes this year to curb inflation, even as ECB President Christine Lagarde emphasized the downside risks to economic growth from the war.

“Central banks are beginning to adjust policy guidance to respond to inflationary pressures,” said Thierry Wizman, Global FX and Rates Strategist at Macquarie Group. “So far, they tend to believe that the impact of energy shocks on inflation is a greater concern than the effects of rising unemployment.”

Federal Reserve Chair Jerome Powell said on Wednesday that the Fed needs to see further progress in taming inflation before resuming rate cuts.

However, if the economy stalls, the Fed might intervene, which could limit the extent of U.S. bond market selloff. Futures markets are pricing in a slightly over one-third chance of rate cuts this year.

“The Fed’s dual mandate makes it stand out among central banks,” said Gargi Chaudhuri, Chief Investment Officer and Head of Portfolio Strategy at BlackRock Americas, in an interview. She believes the Fed is “more likely to focus on growth shocks and ease policy rates. It’s a central bank that, if economic growth is hit, is more inclined to adopt an easing stance.”