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Government bonds in Europe staged their sharpest rally since 2023 on Wednesday, as falling oil prices allowed traders to rein in their bets on interest rate rises following a temporary ceasefire in the Middle East.
Oil prices tumbled on Wednesday after the US and Iran agreed a two-week ceasefire late on Tuesday night, which would see the Strait of Hormuz reopen to shipping traffic. The price of Brent crude dropped 13 per cent to trade about $95 a barrel on Wednesday, its lowest level in nearly a month.
Traders rushed to slash their bets on interest rate rises on Wednesday morning, removing one full quarter-point increase from both Bank of England and European Central Bank expectations, as the falling oil price soothed fears of a serious global inflation shock.
“If energy prices stabilise and growth holds up better than feared, central banks are unlikely to deliver the tightening now priced into markets,” said Neil Shearing, group chief economist at Capital Economics.
In the Eurozone, traders are now pricing two quarter-point rate increases this year, according to levels implied by swaps markets, with the first rise expected by June. On Tuesday, markets were pricing three rate rises this year by the ECB.
For the Bank of England, markets are expecting only one rate increase this year, compared with two rises priced in on Tuesday. Investors are now anticipating the first rise by September, while on Tuesday this was expected at the bank’s June meeting.
Changing interest rate expectations fueled a bond market rally on Wednesday, which sent European yields tumbling. Bond yields fall when the price rises.
Short-dated bonds, which are closely tied to interest rate expectations, rallied especially sharply. Those bonds suffered the steepest losses in the early stages of the conflict when investors started to slash bets on interest rate cuts and instead price tighter monetary policy — particularly in energy-importing economies such as the UK and Eurozone that are exposed to an oil and gas-driven inflation shock.
Two-year gilt yields fell 0.24 percentage points to 4.17 per cent on Wednesday morning, while two-year German bond yields dropped 0.24 percentage points to 2.49 per cent — the biggest daily moves for more than three years.
Longer-dated bonds also saw their biggest moves since 2023, with the 10-year gilt yield down 0.21 percentage points on Wednesday morning to 4.7 per cent. German yields of the same maturity fell 0.16 percentage points to 2.92 per cent.
US Treasuries also rallied, sending the 10-year yield 0.11 percentage points lower at 4.24 per cent.
“The ceasefire has temporarily removed a large geopolitical risk premium, particularly from oil” which “improves the growth-inflation mix”, said Altaf Kassam, head of investment strategy for Europe at State Street Investment Management.
However, Kassam pointed out that the ceasefire is “time limited and fragile” and so “markets will need evidence of sustained energy flows and political follow‑through before repricing this as a durable turning point”.
Bonds markets have a lot further to go to recoup all of their losses since the start of the war. Before the conflict began, investors were betting on two quarter-point cuts by the Bank of England while the European Central Bank was expected to stay on hold.
“Even if the strait is opened, it could take months for energy supply to revert to normal levels,” said Mohit Kumar, chief European economist at Jefferies, adding that “Europe would fare worse than the US from a macro perspective” due to its reliance on imported energy.
Data visualisation by Ray Douglas and Jonathan Vincent