ECB rate hike expectations “cool overnight”! Ceasefire agreement boosts market, European bonds see biggest single-day gain since 2023

The ceasefire agreement between the US and Iran has triggered a chain reaction: oil prices plunged 13% in a single day, European bond markets saw the strongest one-day surge in more than two years, and market bets on rate hikes by the ECB and BoE have narrowed significantly.

Late Tuesday night, the US and Iran reached a two-week ceasefire deal, reopening the Strait of Hormuz to shipping. Following the news, Brent crude plummeted 13% on Wednesday to around $95 per barrel, hitting a nearly one-month low.

The sharp drop in oil prices quickly eased market concerns about a global inflation shock, prompting traders to rapidly reduce rate hike bets in the morning. Markets removed an expected 25-basis-point rate hike each for the ECB and the Bank of England.

This shift in expectations directly drove a strong rally in the European bond market. The two-year UK gilt yield fell 24 basis points in one day to 4.17%, and the two-year German bond yield also dropped 24 basis points to 2.49%, both marking the largest single-day moves in over three years. Longer-term bonds also surged simultaneously, with overall gains being the strongest since 2023.

Rate hike expectations plunge; short-term bonds lead gains

After the ceasefire deal was finalized, rate expectations for the eurozone and the UK saw a clear downward adjustment. According to implied pricing in the swaps market, Wednesday saw the ECB's rate hike forecast for this year drop to two 25-basis-point hikes, with the first expected no earlier than June. On Tuesday, markets had priced in three hikes for the year.

For the Bank of England, markets currently expect only one rate hike this year, down from two previously, with the first expected to shift from June to September.

Short-term bonds, which are closely tied to rate expectations, saw especially prominent gains. During the initial outbreak of conflict, short-term bonds suffered the most brutal declines, especially in energy-importing economies like the UK and the eurozone, amid inflation concerns driven by rising oil prices. Now, with oil prices falling back, these bonds have rebounded sharply.

Long-term bonds also performed strongly. On Wednesday morning, the 10-year UK gilt yield dropped 21 basis points to 4.70%, and the 10-year German yield fell 16 basis points to 2.92%, both recording the largest single-day drops since 2023. US Treasuries followed suit, with the 10-year yield falling 11 basis points to 4.24%.

It is worth noting that before the conflict broke out, markets expected the Bank of England to cut rates twice this year, while the ECB was expected to hold steady. Current market pricing shows that the risk-driven rate hike expectations have only been partially corrected, and the bond market has not fully returned to pre-war levels.

Analysts: Ceasefire fragile, rebound sustainability in question

Several market participants are cautious about the sustainability of this rebound.

Neil Shearing, Group Chief Economist at Capital Economics, commented, "If energy prices stabilize and economic growth exceeds expectations, the likelihood of central banks implementing the tightening implied by current market pricing will be greatly reduced."

Altaf Kassam, European Investment Strategy Director at State Street Investment Management, pointed out that the ceasefire "has a time limit and is quite fragile." The market needs to see "continued recovery in energy supply and further political follow-ups" before pricing this rally as a lasting turning point.

Mohit Kumar, Chief European Economist at Jefferies, shares a similar view, noting, "Even with the reopening of the Strait, it may take several months for energy supplies to return to normal." He added that due to Europe’s high dependence on imported energy, "from a macro perspective, Europe’s situation will be more unfavorable than that of the US."

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