Global bond markets are experiencing significant selling pressure as ongoing Middle East conflicts drive energy prices higher. Investors are increasingly betting that interest rates will remain elevated for an extended period, with some anticipating further monetary tightening, reflecting rapidly growing concerns about inflationary shocks.
Market expectations have shifted dramatically in the three weeks since the outbreak of the Iran conflict. Previously, there was broad consensus that major central banks would cut rates this year to support economic growth. However, as oil and natural gas prices continue to surge, this outlook has been quickly overturned. Investors are now repricing interest rate trajectories, betting that central banks will prioritize tackling inflation risks.
The UK bond market has been the hardest hit in this selloff. The yield on the UK 2-year government bond surged by 40 basis points to 4.49%, approaching the volatile swings seen during the market turmoil triggered by former Prime Minister Truss's fiscal policies in 2022. The Bank of England stated on Thursday that it is "prepared" to take action to prevent further acceleration in inflation, reinforcing market expectations of potential policy tightening.
European markets are also under pressure. Short-term German bond yields rose by 8 basis points, with traders maintaining bets that the European Central Bank will implement at least two rate hikes this year. Although the ECB has kept rates unchanged for the sixth consecutive time, President Christine Lagarde warned that the conflict poses downside risks to economic growth, highlighting the policy dilemma facing policymakers.
The US bond market has also seen adjustments. The yield on the 2-year US Treasury note climbed to 3.82%, after Federal Reserve Chair Jerome Powell's remarks were interpreted by markets as signaling that rates may remain unchanged this year. Compared to three weeks ago, when markets still expected two Fed rate cuts, interest rate futures now show a significantly reduced probability of easing this year.
Market participants note that the bond selloff is concentrated in short-duration securities, which are most sensitive to policy changes, reflecting a rapid shift in monetary policy expectations. Brij Khurana, a portfolio manager at Wellington Management, stated that markets previously assumed the conflict would end quickly, but concerns that the war may last longer are finally being priced in.
Surging energy prices are the core driver behind this shift. As conflicts escalate in the Persian Gulf, threatening key energy infrastructure, oil and gas prices have climbed further, intensifying upward pressure on inflation. Recent statements from central banks also indicate a shift in policy focus from supporting growth to guarding against inflation.
Bank of England Governor Andrew Bailey emphasized that policy must address the risk of more persistent inflation. Thierry Wizman, a strategist at Macquarie Group, noted that central banks are adjusting their guidance, moving from a previous bias toward rate cuts to a greater focus on hikes or maintaining high rates to counter inflationary pressures from energy shocks.
This trend is also visible in Japan. Bank of Japan Governor Kazuo Ueda indicated that a rate hike in April remains possible, pushing Japanese government bond yields slightly higher. In the US, however, the Federal Reserve maintains greater policy flexibility due to its dual mandate of employment and inflation. Powell stressed that further disinflation is needed before considering rate cuts, but if economic growth slows significantly, the Fed could still pivot toward easing.
According to Gargi Chaudhuri, a strategist at BlackRock, the Fed is more likely than other central banks to prioritize rate cuts in the face of a growth shock.
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