Investors are betting that central bankers could be forced to raise interest rates in response to the Iran war, as an energy price shock triggers a dramatic reassessment of previous expectations for further cuts.
The European Central Bank is now expected to lift its key rate by a quarter of a percentage point at least once this year as volatile oil and gas prices reignite inflationary pressures, according to levels implied by swaps contracts. Traders had previously priced a roughly 50 per cent chance that the ECB would continue the cutting cycle it began in 2024.
The swaps market also briefly priced a rate increase from the Bank of England as being likely this year on Monday morning before the bets faded as oil prices fell back. The market later suggested a small chance of a rate cut this year — still a sharp turnaround from the two quarter-point rate cuts fully priced in before the conflict broke out.
Investors have also started dialling back expectations for further US rate reductions by the Federal Reserve this year, with just one or two quarter-point cuts priced into futures markets, down from two or three before the conflict began.
The bets reflect a belief that policymakers have learnt bitter lessons from the inflationary surge that followed Russia’s full-scale invasion of Ukraine in 2022, when most central banks were seen as far too slow to respond to an acceleration in consumer prices.
“We are seeing a global repricing of risk,” said Frederik Ducrozet, head of macroeconomic research at Pictet Wealth Management. “Bond markets woke up [on Monday] morning to the possibility that oil prices might not rise to $100 [a barrel] but to $150 or even $200.”
Central bankers have traditionally opted to sit tight and “look through” big surges in the oil price, as they bet that higher costs will ultimately bear down on consumer demand and damp the longer-term inflationary implications.
But policymakers were accused of acting too slowly after the energy price rise in 2022, meaning they were likely to be more aggressive as they seek to quell more persistent inflationary pressures, analysts warned.
“Central banks are haunted by the experience of the past few years — they wish with hindsight they had acted more promptly in the face of rising inflation expectations,” said Michael Saunders, economic adviser to Oxford Economics and a former BoE rate setter.
“I assume they have basically learnt that lesson, and rather than waiting for second-round effects to appear, which is what they did last time, they will assume these will appear and start to either tighten or loosen less than otherwise.”
For now, ECB policymakers are warning about the inflationary implications of an extended conflict but have not suggested that an immediate response is imminent.
Philip Lane, the ECB’s chief economist, said last week that a prolonged war in the Middle East and a persistent fall in oil and gas supplies from the region could cause a “substantial spike” in inflation and a “sharp drop in output” in the Eurozone.
Deutsche Bank analyst Henry Allen wrote in a note to clients on Monday that “officials aren’t signalling a shift and there’s been no policy adjustment yet”.
Karsten Junius, economist at J Safra Sarasin, said that rate-rise expectations were “overshooting” at the moment. He pointed to the fact that the ECB is at present forecasting six quarters of inflation below its 2 per cent target until the end of next year, which leaves some leeway for faster price rises.
Should the war in the Middle East result in a 15 per cent increase in oil prices this year, it would lift euro-area inflation by 0.25 percentage points to 2.1 per cent — a level that was still “entirely in line” with the ECB’s medium-term 2 per cent target, Junius said.
Before the US and Israel launched their attacks on Iran, investors were betting on two more rate reductions by the BoE this year, with another downward move priced in as soon as next week’s meeting.
Markets now see a very small chance of one cut this year and a small chance of rate rises next year, according to levels implied by swaps contracts.
The Iran war has hammered the value of short-term UK government debt, with two-year gilt yields up more than 0.4 percentage points since the conflict began to about 4 per cent. Bond yields rise as prices fall.
Some investors expect the BoE to be reluctant to increase interest rates during an energy shock that hurts growth and pushes up prices. The UK labour market is already weakening and the economy barely grew at the end of last year.
“The [UK] economy could plausibly enter a short recession,” said Tomasz Wieladek, chief European macro strategist at T Rowe Price. “The Bank of England is aware of that and will therefore likely keep rates on hold rather than outright hike at this stage.”
Others say hedge funds exiting bets on short-term government debt and related derivatives are fuelling the shifts in interest rate expectations.
But at 3 per cent, UK inflation remains well above the BoE’s 2 per cent target. While household inflation expectations have receded, the public was expecting consumer price growth of 3.3 per cent in the coming year even before the Iran war, according to a monthly survey from YouGov for Citigroup.
The BoE was heavily criticised for being slow in responding to the burst of inflation that began in 2021, driven initially by the after-effects of the coronavirus pandemic and then by rising commodity prices as the Ukraine war disrupted supplies. The view that this would be “transitory” turned out to be misguided as UK inflation went on to peak above 11 per cent in the autumn of 2022.
The BoE has been overhauling its forecasting and communications, informed in part by an excoriating report by former Fed chair Ben Bernanke in 2024, placing greater emphasis on how it might react to potential “scenarios” and less on its central forecast.
The fallout from war in the Middle East is affecting a widening range of central banks. Only a few months ago, traders were betting that the Swiss National Bank, whose benchmark interest rate sits at zero per cent, could push that below zero to deal with its soaring currency.
But now one quarter-point increase is seen as likely this year. The shift in expectations has dragged Switzerland’s two-year bond yields back into positive territory.
The Bank of Canada, which was viewed as more likely to cut before the Middle East conflict began, is also expected to make a quarter-point increase by the end of this year, according to swaps contracts.
Pictet’s Ducrozet said the “key variable to watch” for the ECB would be inflation expectations, pointing to board member Isabel Schnabel’s speech on Friday when she said “central banks should focus on anchoring expectations rather than trying to fine-tune economic activity”.
“I think and hope [the ECB] will just do nothing,” Ducrozet said. However, he added that “nothing can be ruled out at this stage” as the ECB was still suffering from “significant trauma from the previous inflation shock”.
Data visualisation by Ray Douglas
