Government bond markets from the euro zone to the United States and Britain experienced a marked selloff on Tuesday as an intensification of the Middle East conflict pushed up oil and gas prices and revived fears about rising inflation. The moves were most pronounced in two-year, rate-sensitive notes, whose prices fell and yields rose across major markets.
Market participants pointed to the disruption of shipping through the Strait of Hormuz - which carries roughly one-fifth of the world’s oil consumption and substantial volumes of liquefied natural gas - as a key driver. With shipments at a near halt, Brent crude climbed 6% on the day to $82.40 a barrel. European wholesale gas benchmarks, which closed roughly 35-40% higher on Monday, were up another 36% on Tuesday.
Rates and yields
Short-dated debt bore the brunt of the reaction. Britain’s two-year gilt yield rose 15 basis points to 3.79%, leaving it 27 basis points higher since Friday’s close and marking its biggest two-day advance in nearly a year and a half. German two-year yields increased 10 basis points on Tuesday and are up 17 basis points versus Friday, their largest move since July. U.S. two-year yields were 6 basis points higher on the day.
Benchmark 10-year yields also climbed: Britain’s 10-year yield rose 16 basis points to 4.53%, Germany’s increased 9 basis points to 2.80%, and the U.S. 10-year yield was up nearly 5 basis points to 4.10%.
Central bank reaction and market pricing
Traders rapidly adjusted their expectations for monetary policy. In Britain, where the Bank of England is due to meet later this month amid a sharp division among policymakers between prioritising inflation or economic growth, markets cut the probability of a rate reduction this month to about 25% from 75% on Friday.
Across the Atlantic, markets appear unlikely to fully price a Federal Reserve rate cut until September. With the European Central Bank, traders moved away from pricing a near-term cut and are now attributing a small chance of a rate increase by year-end, compared with a roughly 40% probability of a cut late last week.
Philip Lane, the ECB’s Chief Economist, told the Financial Times in an interview that a prolonged war in the Middle East could cause a substantial spike in euro zone inflation and reduce economic growth.
Market context and investor positioning
Rohan Khanna, head of euro rates strategy at Barclays, said investors were reverting to the energy-shock playbook of 2022. "Investors are basically going back to the 2022 energy-shock template. That is very fresh in our minds. We saw how large and persistent the inflation shock was," he said, referring to the initial impact of Russia’s full scale invasion of Ukraine. Khanna added that while the initial moves were driven by the spike in energy prices, the selloff was intensified by the fact many investors had been positioned for shorter-dated yields to fall on worries about AI-driven disruption to the underlying economy.
Europe’s status as a net importer of oil and gas was highlighted as a structural vulnerability. The scale of recent energy-price moves is visible in both crude and gas benchmarks described above.
Inflation data and policy implications
Euro zone inflation data released on Tuesday showed consumer prices rose 1.9% year on year last month, exceeding expectations. A market gauge of euro zone inflation expectations over the next two years increased to just over 2% on Tuesday from around 1.8% on Friday.
Analysis by the ECB suggests that a permanent oil price spike of the magnitude markets are currently pricing could lift inflation by 0.5 percentage points. Monetary policy works with long lags and is not effective against transitory shifts in energy prices, so central banks will be closely monitoring how long elevated energy costs persist and whether they trigger second-round effects such as higher wages or broader price increases.
Frederik Ducrozet, head of macroeconomic research at Pictet Wealth Management, noted the uncertainty policymakers face. "It’s too early to tell (the economic impact of the conflict) and that’s going to be the official line - if I have to guess - into the next (ECB) meeting," he said. "But also it’s also true that they have to be careful in case you really face a sustained oil shock," Ducrozet added.
Implications for markets and the economy
The combination of rising energy costs and a rapid repricing of short-term rate expectations increases the risk of volatility in interest-rate sensitive assets. Bond markets have already registered sharp moves, and the speed of repositioning among traders underlines how sudden geopolitical shocks can change the outlook for monetary policy.
How long elevated energy prices persist, and whether they produce persistent inflationary effects, will be the central question confronting policymakers and investors in the weeks ahead.