Key TakeawaysEnergy prices continue to soar as a result of the Iran war, upending assumptions about falling inflation and interest rates.UK government bond yields have spiked as markets scale back the likelihood of interest rate cuts.Fund managers say the Bank of England is better prepared for an inflation shock than in 2022.
UK stock and bond markets have shown a dramatic response to the outbreak of war in the Middle East this week, reflecting changed assumptions about the future path of UK interest rates.
Investors have sold out of short-dated UK government bonds, sending yields soaring, as markets fear an inflationary shock may cause the Bank of England to row back from further interest rate cuts. Yields on two-year UK gilts have risen just over 40 basis points this week, the biggest one-week increase since August 2024.
And shares in UK banks and housebuilders have also fallen this week as investors reprice the likelihood of “higher for longer” mortgage rates.
Prior to the conflict’s outbreak, swaps markets had priced in a near-certain cut to UK interest rates when the Bank of England’s Monetary Policy Committee next meets on Mar. 19. That likelihood has now dropped to less than 20%, according to futures markets, which also point to no further rate changes this year. This follows four interest rate cuts in 2025 and two in 2024.
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“Clearly, there are expectations of a more cautious central bank facing a potential reacceleration of inflation over the coming quarters—albeit a temporary one, since energy price shocks are that classic textbook transitory, supply-side shock,” says Morningstar economist Grant Slade.
“There’s certainly an open question as to how high energy prices go in the near term, and therefore how significant a supply-side shock this turns out to be. That will determine how much more cautious the Bank of England is in normalizing interest rates in coming quarters.”
How the Iran War Could Push UK Inflation Higher
As a major oil importer, the UK and Europe are likely to feel the inflationary impact of higher energy prices more than other major economies, experts say.
Economists at Oxford Economics estimate the conflict in the Middle East could add 0.4 percentage points to UK inflation this year.
But Artemis fixed income manager Liam O’Donnell argues the impact is unlikely to be as dramatic as the inflationary shock witnessed following Russia’s invasion of Ukraine in February 2022, however. The conflict caused an energy supply shock due to Europe’s reliance on Russian gas, which sent UK inflation spiraling to a 41-year high of 11.1% in October 2022.
“The MPC and central banks generally were behind the curve back then,” says O’Donnell.
“We were coming off the back of an extended period of a post-covid global supply shock. Inflation was 5.5% and rising, and central bankers were just dismissing this as a transitory shock.
What the Iran War Means for European Inflation and Interest Rates 
“Today, the central banks have more credibility and we’re in a much better starting position.”
UK inflation has been falling for the past two years, with the latest data for January coming in at 3%. In February 2026, the Bank of England forecast a return to the 2% inflation target by April 2026.
“We can’t be complacent – financial conditions could tighten if energy prices continue to rise,” the Artemis manager adds.
“But the market believes the central banks are alert to the inflation threat so, as serious as this situation is, we don’t see it giving rise to a major macroeconomic shock.”
Will the Bank of England Cut Interest Rates in March?
With the Bank of England previously set to cut before the outbreak of war, ING’s developed markets economist, James Smith, says UK interest rates still have further to fall despite the fresh uncertainty.
Recent Bank of England monetary policy decisions have been decided by a single vote, and Governor Andrew Bailey has previously said decisions are becoming more finely balanced as interest rates approach their terminal level, the end of the current cutting cycle that started in 2024. Uncertainty around the length of the conflict could therefore tip MPC members in favor of a more cautious stance, economists say.
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Smith says if energy prices stay at or above current levels, it’s hard to see the Bank cutting rates in March, but that doesn’t rule out rate cuts in the coming months.
“We’ve pushed back our call for the next cut to April—though a significant de-escalation over the next few weeks could yet bring a March move back onto the table.”
Why UK Bond Yields Are Rising Amid the Iran War
Yields on UK government bonds have spiked since the outbreak of the conflict last weekend. While the short end of the curve has seen a more dramatic impact, 10-year gilts have risen almost 0.4 percentage points to 4.64%.
Marlborough bond manager James Athey says the moves are a “classic response” to a stagflation shock: higher inflation, lower growth and reduced probability of rate cuts equal a flatter yield curve.
“We don’t believe central banks should respond to this sort of shock with higher rates. We think labor markets are too weak to permit significant wage/price spirals to occur, which is why we’ve used weakness in the bond market to add duration in the UK.”
Markets are still pricing in a more benign oil shock scenario, however, adds Morningstar’s Slade.
“There are also more severe scenarios that would impact not just oil but also gas, such as a structural blockage in the Strait of Hormuz, or significant damage to gas infrastructure that would mean it takes much longer for production to ramp back up in Qatar and for supply and prices to begin to normalize.
“Those scenarios don’t really seem priced in at this point given where inflation expectations have moved. So there’s certainly potential for gilt yields to move higher from today’s levels.”
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