Energy inflation suppresses rate cut expectations, Iranian war threatens European bond market.

The stabilization of the European bond market lasted only one day. Following the sharp drop in early March, government debt in the Eurozone and the UK continued to decline on Thursday, due to the lack of signs of easing in the Iran war and continued soaring energy prices. German government bonds, seen as the Eurozone's primary safe-haven asset, faced their worst week in a year. Despite the global government bond prices plummeting this week, Europe is particularly sensitive to the outbreak of conflict in the Middle East, given its high dependence on energy imports. This makes the region highly susceptible to the impact of an inflation rebound. The crisis has shocked investors, who had been confident that the European Central Bank would maintain interest rates this year - an expectation that had pushed the expected volatility index to its lowest level in five years last month. In the UK, it is widely believed that policymakers will cut interest rates this month to support demand for UK government bonds, given the slowdown in the labor market and weakening inflation. However, airstrikes by the US and Israel on Iran last Saturday and the outbreak of war have forced analysts to reassess their previous interest rate forecasts. Given the uncertainty of inflation prospects, Morgan Stanley no longer expects the European Central Bank to cut interest rates twice in 2026, and traders are now beginning to anticipate the possibility of rate hikes. David Zahn, Head of European Fixed Income at Franklin Templeton, said, "We believe that inflation rates in Europe could be higher." While he does not expect a rate hike in the short term, an increase in rates "could come sooner." Regarding the UK, due to the negative supply impact of rising natural gas and oil prices, ING has removed expectations of rate cuts from its 2026 rate forecast. Goldman Sachs has also postponed expectations of further interest rate cuts by the Bank of England. The duration of the conflict is key to understanding the potential for inflation in Europe and its impact on economic growth. The Strait of Hormuz is of particular concern, as it is a vital route for oil tankers transporting oil to and from the Middle East. Although Iran claims the strait is not blocked, traffic in the strait has essentially come to a halt due to danger. Elwin de Groot, Head of Macro Strategy at ING, wrote in a report that the closure of the strait could trigger a "chain reaction, systemic global crisis" with impacts extending far beyond the oil and gas sectors. He said, "An energy supply interruption could quickly spread to industries including petrochemicals, fertilizers, food production, metals, the power grid, semiconductors, and ultimately affect national finances and public order." Given the region's vulnerability, the pressure on the euro is evident, leading to the euro falling below parity with the dollar during the energy crisis sparked by the Russia-Ukraine war in 2022. On Thursday, Brent crude oil prices climbed to around $84 per barrel, with a cumulative increase of nearly 15% this week, while WTI oil prices approached $77 per barrel. Although there have been signs that both sides are inclined to a ceasefire, investors are gradually realizing that the conflict may last longer than initially anticipated. On Thursday, reports indicated that Iran hinted at being prepared to abandon its uranium stockpile, which boosted bond prices to regain some lost ground, but yields quickly rose again. This week, the 10-year German bond yield rose by 15 basis points, while the UK's equivalent bond yield rose by 25 basis points. The surge in oil and natural gas prices highlights Europe's vulnerability: when energy prices rise, the region's trade balance worsens, and the currency often reflects this pain - the euro weakening. This week, due to the rise in oil prices by more than 15% caused by the Middle East conflict, natural gas prices doubling, the currency fell by about 2% against the dollar. Pooja Kumra, Senior Interest Rate Strategist for the UK and Europe at TD Bank, said that the market's vulnerability indicates disappointment among investors at the lack of any reassuring communication from central banks. She added that despite this, the significant uncertainty makes it difficult to determine the policy path at this stage. Central bank governors are beginning to assess the potential impact of the war. This includes European Central Bank Vice President Bindos, who said on Thursday that if the war continues, inflation expectations will change. He emphasized that before the outbreak of war, the European economy had resilience, but now the economic prospects in Europe depend on the course of the conflict.