Iran war escalation wakes markets up to risks of deeper economic pain

By Yoruk Bahceli and Samuel Indyk

LONDON, March 19 (Reuters) - Investors reassessing the potential economic fallout from the war in Iran are selling assets across the globe, from government bonds to stocks and gold, reigniting fears that markets may become vulnerable to a bigger dislocation.

Oil prices jumped to as high as $119 a barrel on Thursday as Iran attacked energy facilities across the Middle East following Israel's strike on its South Pars gas field.

European gas prices surged 22% in just one day, highlighting the region's energy dependency.

The pain was felt globally and exacerbated by hawkish signalling from central banks including the U.S. Federal Reserve, with all G7 central banks meeting within less than 24 hours in a rare coincidence.

Traders, growing more worried about inflation risks, are no longer confident the Fed will cut rates this year and boosted the rate hike bets they've put on across Europe's central banks, which they expect to be more responsive to higher energy prices after a 2022 energy crisis sent inflation soaring.

These worries sent government bond yields from Britain to Italy and the United States surging again on Thursday.

The pain was most stark in the UK, where two-year yields, sensitive to interest rate expectations, jumped over 30 basis points (bps). They were set for their biggest daily increase since former Prime Minister Liz Truss's failed 2022 economic plan.

In a sign that investors, who analysts say have priced in a relatively short-lived conflict so far, are growing more concerned, gold XAU= fell 4%. European stocks .STOXX were set for their second biggest daily fall since the conflict broke out.

Even the dollar, a rare winner from the conflict, dropped against peers on Thursday, falling 1% against the yen and 0.6% against the euro JPY=, EUR=.

"For the first time that bought energy infrastructure into the conflict," Lloyds currency strategist Nick Kennedy said, referring to the latest attacks.

"That is a clear escalation and you don't know where that ends up, so markets are right to be a bit more cautious, as it has crossed the Rubicon."

RATE HIKE BETS

The Bank of England vindicated traders' hawkish bets on Thursday, when policymakers voted unanimously to keep rates on hold, and some raised the prospect of raising rates.

Traders now price in two BoE rate hikes by year-end, having expected it would cut rates at this meeting before the war. At one point they priced in a high chance of a third move before governor Andrew Bailey pushed back on market pricing.

At the ECB, which also met on Thursday, traders fully price in two rate hikes and a strong chance of a third by December.

Euro area and U.S. short-dated bond yields surged about 10 bps DE2YT=R, IT2YT=RR, US2YT=RR.

The hawkish repricing first gained momentum following Wednesday's Fed meeting.