Government bond yields in the U.S. and Europe jumped sharply on Friday as market participants increasingly judged that a war-related energy shock will put upward pressure on inflation for an extended period. The surge in oil prices, driven by disruptions and heightened geopolitical risk, has prompted investors to reassess how long central banks can afford to loosen monetary policy while inflation risks mount.
With the oil market tightening, traders are increasingly pricing scenarios in which the U.S. Federal Reserve may need to raise interest rates rather than cut them later this year. "Expectations for a rate cut are fading fast," said Robert Pavlik, senior portfolio manager at Dakota Wealth Management. "You need to get the Strait of Hormuz opened up and you need to get oil flowing, and that would relieve the pressure on oil prices."
In the United States, the benchmark 10-year Treasury yield climbed to levels not seen since last summer. Markets that had been focused on the prospect of further interest-rate reductions this year shifted toward pricing a moderate chance of a Fed tightening before year-end, a material change in expectations that affects borrowing costs across the economy.
Bond yields matter because they underpin rates on corporate credit and home loans. A sudden and sharp rise in sovereign borrowing costs can feed through to higher mortgage and corporate financing rates, pressuring both asset prices and economic growth.
Across the Atlantic, British 10-year government borrowing costs also spiked, reaching their highest levels since the global financial crisis. The 10-year gilt yield (GB10YT=RR) pushed above 5%, a threshold investors view as highlighting Britain’s sensitivity to rising energy costs. In Germany, the 10-year government bond yield climbed to its loftiest point since the euro zone crisis of 2011, touching a high of 3.025% and finishing the session up 7 basis points on the day. As a reminder of market mechanics, yields move higher as bond prices fall and drop as prices rise.
European Central Bank officials cautioned on Friday that inflation risks were growing, though they did not call directly for tighter policy. The caution did not prevent several brokerages from beginning to include rate hikes in their forecasts, with some penciling in moves as soon as April. Earlier in the week, most major G10 central banks, including the Federal Reserve and the Bank of England, held policy meetings and adopted similarly guarded language on inflation risks.
Heightening the market’s sense of risk, three U.S. officials told Reuters that thousands of additional Marines and sailors are being sent to the Middle East, with departures from the U.S. planned roughly three weeks earlier than initially scheduled, according to one of the officials. The news of stepped-up deployments reinforced investor concern about the potential for a prolonged conflict and sustained pressure on energy supplies.
"Nothing positive has happened so far with respect to the war and we’re heading into the fourth week and we’re probably going to have a further build-up of these pressures," said Padhraic Garvey, head of global rates and debt strategy at ING in New York.
Fed Governor Christopher Waller provided insight into how the energy shock has altered internal debates at the central bank. Waller said he had intended to dissent in favor of a rate cut at this week’s meeting because of unexpected job losses in February, but the jump in oil prices and the risk that inflation could prove more persistent persuaded him that a more cautious course was warranted until the economic impacts of the Iran war become clearer. "This is looking like it’s going to be a much more protracted conflict, and oil prices are going to stay high for a longer time," he said on CNBC’s Squawk Box.
Short-dated sovereign debt has been among the hardest-hit segments of the market. Two-year bonds, which are especially sensitive to changing expectations for near-term interest rates, saw pronounced losses. In the U.K., short-dated gilt yields (GB2YT=RR) jumped by more than 30 basis points at one stage on Thursday as prices tumbled. German two-year Schatz yields (DE2YT=RR) ended the day up 12 basis points at 2.566%, a nine-month high; by Friday they were 3 basis points higher at 2.6%.
Before the outbreak of hostilities, markets had been assigning roughly a 40% probability to another ECB rate cut this year. That view has now swung decisively: market pricing has flipped toward nearly a fully priced-in rate hike by June and a roughly 60% chance of one as soon as April.
Some investors are monitoring fiscal policy responses as governments seek to blunt the economic fallout of higher energy costs. Spain’s government on Friday proposed measures worth 5 billion euros ($5.8 billion) aimed at offsetting the local economic impact of the Middle East conflict on energy prices. "A lot of attention today has been on fiscal policy," said George Moran, European macro strategist at RBC Capital Markets in London.
In Italy, where the economy is more reliant on imported energy than many of its neighbors, sovereign bonds have experienced particularly strong selling pressure since the war in late February began. Italy’s 10-year bond yield (IT10YT=RR) rose 6 basis points to 3.846% on Friday after climbing as much as 12 basis points on Thursday. Since the start of the conflict, Italy’s benchmark BTP yields have increased almost 60 basis points, compared with a 45-basis-point rise in French and Spanish yields and a 34-basis-point increase in German Bund yields. That divergence has widened the spread between Italian and German debt to nearly 80 basis points, its largest gap since last October.
Commenting on the broader market reaction, Chris Scicluna, head of research at Daiwa Securities in London, noted the clear inflation upside risks and said the market repricing was understandable: "The sad fact is there are significant upside risks to inflation and therefore the selloff makes sense," he said. "The repricing of the path of interest rates, at least in Europe, looks reasonable in light of the shock to energy prices."
As investors weigh the balance between geopolitical risk, energy markets and central bank policy, bond markets are likely to remain sensitive to developments in the Middle East and to updates from policymakers. The immediate market reaction has pushed yields higher, tightened financial conditions and raised the stakes for fiscal and monetary responses in affected economies.