Oil is in the driver’s seat again, and markets have been quick to reprice for tighter monetary policy. The 2Y EUR inflation swap jumped almost 20bp higher, while markets are once again pricing in close to a full European Central Bank rate hike by September. This aligns with early reactions from ECB officials following the renewed escalation. Bundesbank President Joachim Nagel said he would not rule out another rate hike given we are “back where we started”. Meanwhile, the bearish tone in longer-dated rates that had already been building ahead of the week gathered further momentum, pushing the 10-year Bund yield to around 3.1% by the close.
Risk sentiment also took a hit, which in eurozone government bond markets manifested itself in a widening of spreads over Bunds. Italian spreads had proven particularly sensitive to oil prices during this crisis and widened some 3.5bp in the 10y on the latest spike in energy prices. France, though, underperformed slightly this time, facing the additional layer of uncertainty surrounding its domestic politics and fiscal trajectory.
There is one difference now compared to when the Iran crisis initially hit bond markets. Real rates are now a lot more elevated than a few months ago. Markets seemed to have taken a more upbeat view on global growth, especially in the US.
This more upbeat take on the economy and the labour market was also reflected in the more hawkish stance of the Fed, which was just confirmed by the minutes of the June meeting. While voting unanimously to keep rates on hold, that meeting saw nine Fed officials pencilling in higher rates by the end of this year. Most officials agreed that “some policy firming would likely be warranted” in a scenario in which inflation remained elevated due to strong AI-driven demand, high energy prices and tariffs. This is not our base case for inflation, where we see more room for moderation.
But with the Fed on a more hawkish footing and real rates starting out higher, it means nominal rates can potentially test new highs if the inflation expectations component starts to rise again more noticeably. At the end of last month, 10y inflation swaps had seen their lowest levels since spring 2025 but are now already some 7bp off these lows. At one point on Wednesday, the nominal 10y UST yield was just 10bp shy of the 4.7% we hit when oil was trading well above $100 per barrel.