Iran, energy shocks and the inflation challenge

As the US-Israeli military operation in Iran enters its fourth day, markets are continuing to react to rhetoric from both sides and attempting to gauge how long the conflict may last and what the impact will be on the local and global economies.

Monday’s reaction was relatively calm in credit markets. Spreads initially widened but recovered through the session to finish broadly unchanged versus Friday’s close. US equities showed a similar pattern, with the S&P 500 index rebounding from pre-market losses of around 1.7% to close modestly higher, supported by gains in technology and energy stocks. European indices suffered sharper declines, with Germany’s DAX down 2.6%, France’s CAC 40 down 2.2% and the UK’s FTSE 100 down 1.2% on Monday, and these indices were all down a further 2.5-3% on Tuesday at time of writing. These declines partly reflect a catch-up on the weak Friday session in the US, but the greater proximity to the conflict has also contributed to their relative underperformance.

Rates markets also had a difficult day, which probably came as a surprise to some commentators given the historic “flight to quality” characteristics of developed market government bonds. 10-year US Treasury yields ticked down on Monday morning to a low of around 3.92% but quickly reversed the move and have now pushed up through 4.10%. The shift was echoed in Europe, with 10-year German Bunds 16bp higher and 10-year UK Gilts 20bp higher than Monday’s lows.

The sell-off in rates has been driven largely by rising inflation concerns, unsurprising given the region’s importance to global energy supply. Energy commodities have recorded some of the most significant moves; Brent crude is now up 27% month-to-date and 35% year-to-date, while Dutch natural gas futures have surged nearly 40% month-to-date and 115% year-to-date.

It is impossible to know how the conflict will develop from here, but given President Trump’s suggested timeline of around 4-5 weeks and his suggestion that the “big wave hasn’t even happened yet”, a de-escalation in the short term seems very unlikely. The impact of this on European energy markets could be significant and long-lasting.  

The December 2025 Eurosystem staff macroeconomic projections for the euro area projected that a 14% increase in oil prices and a 20% increase in gas prices in 2026 would cause a 0.5% increase in inflation and a -0.1% impact on GDP growth. These projections assumed a permanent price shock – something that cannot yet be determined. However, further energy shocks are not out of the question given that Qatar – responsible for a fifth of global liquified natural gas (LNG) supply – has ceased production and the conflict has effectively closed the Strait of Hormuz, halting around 20% of global oil and LNG supply.  

It is obviously too early to calculate what impact this conflict will have on inflation, but market moves are now pushing out rate cut expectations in the US, with the first cut being moved from July to September this year, while a second cut is now predicted to be June 2027 rather than October 2026. In Europe, traders are now also pricing a 50% chance of a rate hike from the European Central Bank (ECB) this year.

While the Eurozone would undoubtedly be more impacted than the US, the ECB is in the enviable position of at least having headline inflation close to target – reported at 1.9% on Tuesday, though core inflation did increase to 2.4% vs. 2.2% expected. The US and the UK by contrast were still battling to get inflation to target, with core inflation at 2.5% and 3.1% respectively, and market pricing has slashed the chance of a rate cut from the Bank of England on March 19 from 83% last week to just 16% now.

We do not expect central banks to react hastily, as it is still too soon to assess the longer-term inflationary consequences, and headline inflation tends to be less of a focus for policymakers. However, given current pressures, further rate cuts appear less likely in the near term even as global growth prospects deteriorate. This dynamic is also challenging the traditional safe-haven status of government bonds.

We expect continued volatility in government bond markets, with yields highly sensitive to developments and official commentary. While markets are rapidly repricing expectations for rate cuts and potential hikes, the pace at which the conflict is evolving makes any firm conclusions premature. In credit markets, price action has so far been relatively orderly and measured. However, should conditions become more dislocated, this could create attractive opportunities for active managers to deploy capital selectively in oversold markets.