Investors remained focused on further interest-rate increases across Europe on Thursday, ahead of policy decisions from the European Central Bank and the Bank of England, after a renewed surge in energy costs linked to the U.S.-Israeli war with Iran damped hopes for rate cuts.
On Wednesday the Federal Reserve paused its rate path, keeping policy steady, but the U.S. central bank raised its inflation projection for the year, attributing the revision to quickly rising energy prices. That update clouded the broader outlook for rates and helped cement a more hawkish market stance.
Elsewhere in Europe, the Swiss National Bank and the Riksbank in Sweden both opted to hold policy rates on Thursday. Meanwhile, traders reacted to an oil market that has jumped by more than 50% since the start of the year, recalibrating expectations for how central banks will respond to higher energy costs.
"Overall, I expect (central banks) to be more hawkish just because they have an inflation shock that’s working its way through the system," said David Zahn, head of European fixed income at Franklin Templeton. "Our overall view is that this is definitely inflationary and this means the ECB will be hiking, probably this summer."
Money market pricing has shifted markedly in response. A recent move overnight pushed traders to price in over 55 basis points of ECB tightening by the end of the year, which implies at least two quarter-point increases. The first of those rises is fully priced by June. Before the latest Middle East tensions, some market participants had considered a small probability of a rate reduction this year.
Expectations for the Bank of England have shifted as well. Where a cut this week had been discussed in some quarters prior to the conflict, markets now anticipate that the BoE will not lower rates this year and instead price in at least one hike in 2026.
The broader repricing toward tighter policy has pushed government bond yields higher, with particularly acute implications for economies sensitive to energy costs, including Germany and Italy. Germany's two-year yield, which tends to track near-term rate expectations, has climbed 50 basis points so far this month to its highest level since August 2024. In the UK, the two-year gilt yield rose 17 basis points on Thursday to 4.282%, its strongest level in nearly a year.
In other central bank actions this week, the Reserve Bank of Australia raised its policy rate on Tuesday, flagging a "material" risk to inflation driven by recent developments. That decision made Australia the first major central bank to announce a policy change since the start of the Middle East conflict. The Bank of Japan held rates steady on Thursday but cautioned that rising oil prices could exert upward pressure on inflation.
With central banks and markets closely watching energy prices and geopolitical developments, investors are repricing the path of interest rates across major economies. The evolving outlook is being reflected in money market pricing and bond yields, which have already reacted sharply to the recent shock to energy markets.