Europe’s sovereign debt faces a “perfect storm” as fresh inflation concerns sparked by the Iran conflict forced the region’s central banks to chart a new direction for interest rates on Thursday, sending yields soaring.
The Bank of England kept interest rates on hold at 3.75% on Thursday, while the European Central Bank also kept borrowing costs on hold, as rate setters bear the economic impact of rising energy costs.
yield 10 years giltInterest rates, a measure of British government debt, rose more than 13 basis points to a 52-week high of 4.871% on Thursday, but have since eased. Two-year bond yields, which are typically more sensitive to interest rate decisions, immediately rose 39 basis points, the biggest rise since former chancellor Liz Truss’s “mini-budget” in September 2022. Last time, it rose 27 basis points to 4.378%.
Bonds in France, Germany and Italy were under less intense selling pressure, but yields rose across the continent.
UK 10 Year Gilt.
Market strategists say the BoE’s move – a unanimous decision by the nine-member Monetary Policy Committee – effectively ends hopes of further interest rate cuts this year and marks a dramatic change in the policy outlook from just two weeks ago.
tactical trading
Ed Hutchings, head of rates at Aviva Investors, said it was now more likely that the BoE would raise interest rates in the coming months.
“With this in mind, from an asset allocation perspective, investors may begin to tactically add overweight to government bonds in the near term, and as of today we expect at least one rate hike this year,” Hutchings said.
Matthew Amis, investment director of interest rate management at Aberdeen Investments, described the unfolding environment as a “perfect storm” for European government bond markets.
German 10 year bond.
“Higher energy prices and the Bank of England opening the door to a potential interest rate hike have sent bond prices soaring,” Amis told CNBC in an email. “German Bunds have been relatively calm in this storm, but are still up 3% on similar inflation concerns.”
“Bonds and Bundestags are pricing in a much longer-term conflict than other markets, with markets focused on the inflation spike while not yet focusing on the potential negative impact on growth.”
Meanwhile, the ECB’s next move is likely to be a rate hike, said Simon Dangor, deputy chief investment officer and head of fixed income macro strategy at Goldman Sachs Asset Management.
“The board is clearly sensitive to upside risks to inflation, but will likely seek to assess the impact of a potential second round before taking action,” Dangor said. “A rate hike could therefore occur in the second half of 2026, but the ECB is prepared to act sooner if the situation worsens.”
“Economical Dunkirk”
Energy prices continued to rise on Thursday, with international benchmark Brent crude oil rising 3.5% to $111.10, and natural gas prices also rising.
Europe has sought to diversify its energy mix following the 2022 price shock caused by Russia’s invasion of Ukraine. However, the continent remains a net importer of both oil and gas.
Brent crude oil.
“Thanks to the Iran war, yields are waking up to an economic Dunkirk in the face of the global economy,” Chris Beauchamp, chief market analyst at IG, told CNBC in an email. “As the outlook darkens, investors will demand higher borrowing costs from European countries, and only if Brent is at $110.”
Looking ahead, Amis said the bond market could start to look attractive if true détente occurs soon. In that case, the current forecast for a rate hike at the end of 2026 could be quickly reversed.
“However, with no clear end in sight at this point, European sovereign markets will remain volatile as central bankers unwind their ‘what we did wrong in 2022’ playbook,” Amis added.
But Nicholas Brooks, head of economics and investment research at ICG, said Thursday’s spike in yields may be short-lived. He said oil prices would need to stay above $100 for an extended period of time before the ECB would consider raising rates, suggesting the central bank was likely to keep its benchmark rate unchanged.
“Sustained increases in energy prices will likely delay the Fed and central banks from cutting rates, but we believe the central banks have room to cut rates by the second half of this year,” Brooks told CNBC in an email.
“While there is considerable uncertainty in the outlook, our base case remains that energy prices will stabilize in the coming weeks and months and government bond yields will decline from current levels,” he said.
