Global expectations of loose monetary policy are coming to an end? Rising oil and gas prices reignite speculation of interest rate hikes, with the market betting on Europe shifting towards a hawkish stance.

With the soaring energy prices intensifying market concerns and panic about the skyrocketing inflation and the economy heading towards "stagflation", traders have increased their bets on the European Central Bank and the Bank of England to start a rate hike cycle. In contrast, before the outbreak of the war between the United States/Israel and Iran, the market was betting that the European and UK central banks would continue to cut rates in the second half of the year. For the Federal Reserve, the European Central Bank, and other global central banks, "stagflation" is perhaps the most difficult long-term economic dilemma among all macroeconomic challenges. As of the time of writing, the international crude oil pricing benchmark - Brent crude oil futures prices have surged by over 15%, maintaining above $100 per barrel, with a previous high of up to 30% increase. The core reason is the complete interruption of oil and gas transportation in the Strait of Hormuz, leading to major oil-producing countries in the Middle East reducing production. The early trading surge in oil prices marks the largest single-day increase since April 2020 and the highest oil price level since June 2022, following last week's 27% surge. Oil prices briefly surged to around $120 per barrel on Monday, rising nearly 80% since the outbreak of the Iran war, prompting the market to interpret it as an impact of "higher inflation + more pessimistic economy", leading to stagflation shock. The forward market shows that traders currently estimate the probability of the European Central Bank raising interest rates by 25 basis points twice this year to be around 70%, compared to last Friday when the market only estimated one rate hike with a probability hovering at 50%. The first rate hike has already been fully priced by the market, with the first rate hike expected in July or earlier. At the same time, currency market traders currently believe that the probability of the Bank of England announcing a rate hike by the end of the year is around 50%, completely reversing the rate-cut betting prevailing last week. As shown in the chart above, traders have fully priced in two rate hikes by the European Central Bank this year in response to the concerns raised by the soaring energy prices. In the US market, concerns about inflation and the increasing probability of "stagflation" have prompted traders to significantly delay their expectations of the next 25 basis point rate cut by the Federal Reserve to September, with the general expectation that the Fed may only cut rates once this year. At the end of February, just before the outbreak of the military conflict between the US and Iran, traders were largely pricing in the expectation of a rate cut in July, and even pricing in the possibility of two or more rate cuts by the Fed this year. Now, some bond options traders are even betting that the Fed may not cut rates this year in the face of stagflation fears. Evelyne Gomez-Liechti, a strategist at Mizuho International Markets, said, "The monetary policy decision-makers at the European Central Bank and the Bank of England are actually caught in a dilemma: easing monetary policy under the impact of oil prices could risk damaging the credibility of fighting inflation, while tightening policy could endanger the current weak economic growth in Europe." "Our inclination is for euro yields to continue to rise, as the risk of energy prices leading to inflation outweighs any narrative of short-term inflation easing." Gomez-Liechti stated that the risk of energy outweighed the short-term "inflation will continue to fall" narrative, which the market could have told, but now with the Middle East conflict pushing up oil and gas prices, European natural gas prices soaring, oil prices surpassing $100 per barrel, and the US dollar exchange rate continuing to rise, the market will worry about re-emerging input inflation, forcing the European Central Bank to maintain higher interest rates for a longer period or reconsider rate hikes. In the early European trading session on Monday, German bond prices continued to fall (bond prices falling means yields are rising), with short-term bonds sensitive to monetary policy changes leading the decline. The two-year German bond yield surged by 16 basis points to 2.47% at one point, then retraced some gains to 2.39%. Italian bonds were hit hard by a broader sell-off in risk assets, with the spread on the 10-year bonds relative to safer German bonds widening by 5 basis points to about 80 basis points. Meanwhile, the yield on the two-year UK government bonds briefly soared by 30 basis points to 4.17%, before narrowing the gain to 4.10%. In the United States, which has a lower dependency on energy imports, the yield on the two-year government bonds inched up by 4 basis points to 3.60%, but the yield on the 10-year US bonds, known as the "anchor of global asset pricing", rose by over 7 basis points - the largest increase since January, hovering around the recent high of 4.20%. The market's pessimistic expectations of global economy heading towards "stagflation" have been further exacerbated by US President Trump's recent remarks that some regions of Iran have not been hit by US and Israeli military strikes, and that a $100 per barrel oil price is a "very small price" to pay for "security and peace". This has shattered the previous optimistic hopes of the conflict remaining relatively controlled. Just a few days ago, investors were cautiously trading on the "stagflation" theme, but now the trend has shifted to a more definite direction: investors are pricing in a deeper and more sustained oil supply shock - one that could squeeze global economic growth, reignite inflation indicators, lead to a spike in bond market yields, and drive the so-called "stagflation" trading theme. In the latest round of bond sell-offs, European bonds appear more fragile compared to other bond markets, mainly due to Europe's higher sensitivity to external energy shocks, and the "safe-haven premium" of German bonds being structurally weakened. Europe is highly exposed to the global energy market, and in this shock, German bonds are also affected by expectations of German fiscal expansion, the European Central Bank's balance sheet contraction leading to reduced official buying, and foreign investors being more sensitive to yields on European bonds; indicating that European bonds are struggling to serve as stable safe-haven assets. In recent days, more oil-producing countries in the Middle East, including Iraq and the UAE, have cut production, and the navigation channel in the Strait of Hormuz remains practically closed, driving global energy prices higher once again. On Monday, European natural gas prices surged by 30%, with Qatar's supply cut last week leading to a nearly 50% surge in European natural gas prices in a single day; while crude oil futures prices approached $120 per barrel. The current focus of the market is on the extent to which this energy price shock will long-term inflation expectations in the market. An index measuring the risk of inflation in Europe is heading towards its highest closing level since July 2024, rising by 7 basis points to 2.23%. A similar index in the UK is also expected to record the highest closing level since March. This is prompting thoughts of the period of the Russia-Ukraine conflict in 2022: the invasion of Ukraine by Russia greatly pushed up inflation in Europe, forcing the European Central Bank to significantly tighten monetary policy. Isabel Schnabel, a member of the Executive Board of the European Central Bank, stated last Friday that as long as price growth remains roughly in line with the target, the central bank does not need to react, unless consumers begin to raise their inflation expectations. Rainer Guntermann, interest rate strategist at Deutsche Bank, said, "The market is increasingly worried that the dynamics of energy prices could push the European Central Bank out of its monetary policy comfort zone." "If inflation expectations spiral out of control, especially considering the experience of the second round of energy inflation effects in 2022, and all the criticisms of the Fed being late to raise rates, this could force the European Central Bank to take action."