Financial markets worldwide experienced severe turbulence on Friday as mounting concerns about inflation driven by the Iran conflict sent government bond yields soaring across the United States and Europe, with analysts warning the pressure may persist.
Market participants are quickly reassessing central banks’ capacity to loosen monetary policies as the conflict continues. Rising oil costs have increased the likelihood that the Federal Reserve might need to raise interest rates instead of cutting them.
“Expectations for a rate cut are fading fast,” said Robert Pavlik, senior portfolio manager at Dakota Wealth Management. “You need to get the Strait of Hormuz opened up and you need to get oil flowing, and that would relieve the pressure on oil prices.”
Ten-year Treasury yields in America climbed to levels not seen since last summer. Market participants, who had been anticipating additional rate reductions this year, began factoring in a modest probability that the Fed will be compelled to raise rates before year-end. Bond yields serve as crucial benchmarks that influence corporate lending rates and mortgage costs.
Dramatic increases in these rates can negatively impact both economic expansion and asset values. American equities plummeted Friday, pushing the S&P 500 into its fourth consecutive weekly drop for the first time in twelve months, while the Nasdaq fell 2% daily, approaching correction territory with a 10% decline from recent highs.
British ten-year government debt costs also skyrocketed, reaching their peak since the global financial crisis. The benchmark gilt yield exceeded 5%, a threshold widely considered problematic given Britain’s susceptibility to energy price increases.
German ten-year bond yields reached their highest point since the eurozone crisis in 2011. This key European borrowing benchmark hit 3.025%. Bond yields move inversely to prices.
European Central Bank officials cautioned about escalating inflation dangers Friday but refrained from advocating stricter policies, despite numerous financial firms beginning to forecast rate increases starting as early as April.
Major central banks including the Federal Reserve and Bank of England conducted policy sessions this week, expressing similar wariness regarding inflation threats.
Friday brought news from three American officials who informed Reuters that thousands of additional Marines and sailors are being sent to the Middle East, departing approximately three weeks earlier than originally planned.
Subsequently, Iraq announced force majeure on foreign-operated oil facilities due to Strait of Hormuz disruptions, a legal declaration typically used when circumstances beyond one’s control prevent fulfilling contractual obligations.
“Nothing positive has happened so far with respect to the war and we’re heading into the fourth week, and we’re probably going to have a further build-up of these pressures,” said Padhraic Garvey, head of global rates and debt strategy at ING in New York.
Fed Governor Christopher Waller revealed Friday that he had intended to advocate for a rate reduction at this week’s central bank meeting due to unexpected February job losses, but the energy crisis and threat of sustained inflation persuaded him that caution was necessary until the Iran conflict’s impact becomes clearer.
“This is looking like it’s going to be a much more protracted conflict, and oil prices are going to stay high for a longer time,” Waller said on CNBC’s Squawk Box.
American rate futures Friday began incorporating the possibility of interest rate increases later this year, with markets assigning a 32% probability of tightening by November according to LSEG data, up from nearly zero Thursday evening.
Short-term bonds globally have suffered most from inflation anxieties. British short-term gilt yields rose over 30 basis points Thursday as prices collapsed. German two-year yields finished up 12 basis points at 2.566%, reaching nine-month peaks, then gained another 3 basis points Friday to 2.6%.
Before the conflict began, markets indicated roughly 40% odds of another ECB rate cut this year. This has reversed to nearly fully pricing one increase for June and 60% probability for April.
Some investors focused on potential government responses to economic damage. Spain’s administration Friday proposed 5 billion euro ($5.8 billion) measures to address the Middle East conflict’s impact on domestic energy costs.
“A lot of attention today has been on fiscal policy,” said George Moran, European macro strategist at RBC Capital Markets in London.
Italian ten-year yields rose 6 basis points to 3.846%, after Thursday’s 12 basis point spike. Italy’s greater reliance on energy imports compared to neighbors has made its bonds more vulnerable since the late February war outbreak.
Italy’s benchmark yields have climbed nearly 60 basis points since then, exceeding the 45 basis point increases in French and Spanish yields and the 34 basis point rise in German bonds, widening the risk premium to nearly 80 basis points, the largest since October.
“The sad fact is there are significant upside risks to inflation and therefore the selloff makes sense,” said Chris Scicluna, head of research at Daiwa Securities in London. “The repricing of the path of interest rates, at least in Europe, looks reasonable in light of the shock to energy prices.”
