Bond yields rise as energy prices surge

Concerns that rising energy prices due to conflict in the Middle East will push up inflation has led the market to pare back expectations for further Fed and Bank of England (BoE) rate cuts and to price out the already slim chances of any further policy easing by the ECB. The re-pricing of BoE rate expectations helped lift sterling off lows yesterday of circa $1.3315 and £0.8790 against the dollar and euro respectively, though it is revisiting its lows against the US currency this morning while trading at around £0.8740 versus the euro. The single currency is heading further south against the dollar, currently trading at about $1.1630, which is not far off mid-January’s 2026 to date low of just under $1.16.

Oil and gas prices remain under pressure as Iran says the Strait of Hormuz is now “closed.  Brent crude has moved above $80 per barrel again, after briefly dipping back to just under $77 p/b yesterday, while European gas prices are up another 25% today after surging by 40% yesterday. If sustained, higher energy prices will push up headline inflation, which is particularly problematic for the Fed and BoE given inflation in the US and UK – at around 3% – is already running well above the 2% target (Euro area inflation is currently running slightly below target at 1.7%). Expectations for Fed and BoE rate cuts this year have been pared back as a result, to less than 50bps for the former and to just 25bps for the latter, with the next cuts in rates pushed out to late Q3 and beyond. The market has priced out any chance of an ECB rate cut this year, and indeed is now pricing in a small chance of a hike by end-2026.

The re-pricing of interest rate expectations has contributed to a sharp rise in government bond yields. UK and US 2-year yields are up around 12-13bps since last Friday’s close, while German 2-year yields are about 10bps higher. Yields further out the curve have also increased, with 10-year yields up about 12-14bps, essentially reversing last week’s decline in yields. Meanwhile, in equity markets, the S&P 500 (surprisingly) managed to end flat yesterday, erasing earlier losses, but the futures market points to a renewed decline at the open later today. The Euro Stoxx 600, in contrast, shed around 2.5% yesterday and it is down another 1% or so at the open this morning.

ECB Chief Economist Philip Lane says “the scale of the impact” of developments in the Middle East “depends on the breadth and duration of the conflict”, but acknowledges that “there would be a substantial spike in energy-driven inflation and a sharp drop in output if (the) conflict led to a persistent drop in energy supplies and disruptions in regional economic activity.”

For today, the focus for markets will remain very much on the situation in the Middle East and the impact on energy prices in particular. It is very quiet on the economic data front with a flash reading of Euro area inflation in February the only release of note.