UK Gilts Lead Global Bond Rout as War Risks Fuel Global Hawkish Pivot

TradingKey - On Thursday, the Bank of England voted unanimously to maintain interest rates and warned that it stands "ready to act" due to the risk of rising inflation triggered by the war in the Middle East.

Following the Bank of England's announcement, the rate-sensitive two-year gilt yield surged, at one point jumping 40 basis points to reach 4.49%, a new high since January 2025. Bond yields and prices are inversely related. The collapse in gilts quickly triggered a sell-off in Treasuries across the Atlantic, with the two-year U.S. Treasury yield soaring as much as 18 basis points to 3.95% during Thursday's session. Germany's two-year sovereign bond yield also rose by nearly 15 basis points at one point.

Regarding bond market trends, Jeffrey Gundlach, CEO of DoubleLine Capital and known as the "New Bond King," stated that the two-year Treasury yield has risen 50 basis points in less than three weeks, suggesting the Federal Reserve might implement a rate hike.

Oil Prices Ignite Inflation Fears, Reversing Rate Cut Expectations

This round of bond market volatility is primarily driven by the continuous climb in energy prices.

Before the outbreak of the conflict between the U.S. and Iran, the market generally expected the Fed to cut rates at least twice in 2026. Similarly, due to the continuous softening of the UK labor market, the market had also widely anticipated that the Bank of England would announce a rate cut at this meeting. However, crude oil disruptions caused by the war in the Middle East have completely shattered these expectations.

This is because rising oil prices are quickly reflected in the costs of crude products like gasoline and diesel. Energy prices are not only directly weighted in the Consumer Price Index (CPI) but also affect all aspects of production and daily life, thereby driving up inflation. When oil prices rise, market expectations for future inflation also increase.

Europe is highly dependent on energy imports and is therefore considered one of the economies most sensitive to energy prices. Since the conflict erupted, European natural gas prices have nearly doubled. The European Central Bank (ECB) has not only raised its annual inflation forecast but also its core inflation projections (excluding energy and food) for the next three years. The institution expects the energy crisis to transmit price pressures more broadly.

This week, the Federal Reserve passed a resolution to keep the benchmark interest rate unchanged at 3.50%-3.75%. The latest policy statement still maintains a median outlook of one rate cut in 2026. However, looking at market conditions, traders now view this possibility as extremely low. Some even believe that, amid persistent inflationary pressures, the Fed may not only stay on hold but could also restart its tightening cycle. Current hawkish market expectations have surpassed official Fed projections, with the implied probability of a rate hike in the futures market reaching approximately 6%.

On the European front, current swap pricing shows that the market is betting the ECB will implement two 25-basis-point rate hikes this year, with the first potentially as early as April. The probability of a third hike before year-end exceeds 50%.

Amid widespread expectations of rate hikes, the market is demanding higher yields to compensate, leading to a collective plunge in the bond market.

Wall Street Flips to Rate Hike Forecasts

Currently, JPMorgan (JPM) , Morgan Stanley (MS) and Deutsche Bank have already revised their expectations for European monetary policy. JPMorgan currently expects rate hikes in April and July, while the other two investment banks anticipate hikes in June and September.

Regarding the Fed, prior to this bond market sell-off, economists at BNP Paribas had already stated that the Federal Reserve has shifted toward a symmetric policy bias, meaning the likelihood of a rate hike is now roughly equal to that of a cut. Deutsche Bank went further, suggesting it is possible that the Fed could pivot in 2026 and begin raising rates.

Currently, the decisive factor is the future duration of the war. For Europe, the key issue is how long the rise in energy costs will persist and what impact it will have on the prices of other goods and services. The ECB raised its inflation forecast for this year from 1.9% to 2.6%; if energy infrastructure suffers severe damage and supply recovery is slow, the inflation rate next year could approach 5%.