Iran Situation Reshapes Interest Rate Expectations: UK may hike rates four times this year, UK bonds fall back to "Taper Tantrum moment".

Due to the escalation of the situation in the Middle East and drastic fluctuations in international oil prices, the UK financial markets experienced severe volatility in March 2026. As conflicts between the United States, Israel, and Iran intensified, concerns about disruptions in the global energy supply chain peaked, directly increasing inflation expectations in the UK. This sudden change in the macro environment forced investors to quickly revise their optimistic assessments of the Bank of England's impending rate-cutting cycle. Current market pricing indicates that traders have fully factored in expectations for the Bank of England to raise interest rates four times by 25 basis points each in 2026, a stark reversal from the previously anticipated two rate cuts a month ago, making it an extremely rare "policy U-turn". Fueled by these rate hike expectations, UK government bonds (Gilts) are experiencing their most brutal single-month performance since the "Rishi Sunak financial crisis" in September 2022. The index tracking traditional UK government bonds saw a nearly 5% decline this month, approaching the largest drop since an 8% decline in September 2022. This sell-off has wiped out 108 billion in market value of the benchmark index, and as of last Friday's close, the index's market value was 1.63 trillion. The downturn continued on Monday, with the yield on two-year government bonds, sensitive to interest rates, spiking up 30 basis points in a single day to exceed 4.1%, reaching the highest level since February 2024. Meanwhile, the yield on the benchmark 10-year government bond broke through the 5% threshold, setting a new high since the 2008 global financial crisis. Although global bonds have been hit hard since the airstrikes by the US and Israel on Iran, UK government bonds have been one of the worst performers. The UK's reliance on imported energy makes it particularly vulnerable to supply disruptions. Therefore, traders anticipate that the Bank of England will raise interest rates as many as four times this year, with each hike being 25 basis points - a complete opposite of the two rate cuts that occurred before the conflict erupted - as officials vow to control inflation. For UK bond investors, this is a dramatic shift, as the same benchmark index achieved a 5% return in 2025 - the best year since 2020. Many investors were still bullish on UK bonds at the beginning of this year, as decreasing issuance and the widespread expectation of a loose monetary policy from the Bank of England were seen as market supports. However, war changes everything: soaring oil and gas prices could significantly raise inflation and force the Bank of England to tighten its monetary policy. Due to investors closing out their previously bullish positions, liquidity has been poor, exacerbating the plight of bond holders this month. Rising borrowing costs make it harder for the government to adhere to its self-imposed fiscal rules. UK Prime Minister Keir Starmer is scheduled to hold an emergency meeting on Monday with Cabinet ministers and Bank of England Governor Andrew Bailey regarding the Iran crisis. Indeed, the nature of this month's sell-off is different from the crisis in 2022. The surge in yields this month is mainly led by short-term bonds, as traders bet on the Bank of England raising interest rates in the coming months. The yield curve for UK two-year government bonds has risen by over one percentage point so far in March, with the curve flattening. In contrast, the crash in 2022 was mainly caused by long-term bonds and inflation-linked bonds, which are favored by fixed income pension funds. These funds employed highly leveraged strategies, triggering the sell-off when they were eager to meet margin calls. The Bank of England ultimately had to curb the crash through emergency bond buying program. For bond holders experiencing losses, this is another warning. The market is more susceptible to sudden sell-offs, in part because the country's investor base is transitioning from stable domestic buyers to more price-sensitive institutions such as hedge funds and foreign investors. Furthermore, the Bank of England's recent statements at policy meetings have further heightened the market's tightening expectations. Bank of England Governor Bailey explicitly warned that due to external energy price shocks, UK inflation in 2026 could climb to around 3.5%, far above the official target of 2%. Although the central bank kept the benchmark interest rate unchanged at 3.75% in mid-March, its language of being "ready to take necessary action" was interpreted by analysts as a clear hawkish signal. Several authoritative institutions such as Morgan Stanley pointed out that the current UK interest rate market is undergoing one of the most severe shocks in recent history, and bond prices could continue to be under pressure until the global energy crisis is completely resolved. Major international banks have also raised their forecasts for the UK interest rate path, with market sentiment generally pessimistic. J.P. Morgan predicted in its latest report that the Bank of England may implement rate hikes as early as April and July this year to curb potential inflation spirals. Goldman Sachs has retracted its previous forecast of rate cuts for 2026, postponing them until 2027, and emphasized that if the situation in the Middle East leads to blockages in key shipping lanes such as the Strait of Hormuz, the UK will face more prolonged monetary tightening pressures.