Eurozone Debt’s “Darkest Moment”: War Severs Rate-Cutting Path, German Bond Yields See Biggest Weekly Rise in a Year

Less than a week after the outbreak of the conflict between the US and Iran, the European bond market has already suffered heavy losses. Inflation worries triggered by soaring energy prices are forcing investors to completely reassess the interest rate paths of the European Central Bank and the Bank of England.

On Thursday, government bonds in the eurozone and the UK continued to fall, with the yield on Germany's 10-year bonds rising by 18 basis points throughout the week, and the yield on UK bonds of the same maturity surging by 29 basis points. German government bonds are facing one of their worst weekly performances in nearly a year, and the yield on German two-year bonds also saw the largest weekly increase since 2023.

According to Bloomberg,Morgan Stanley has withdrawn its forecast for two ECB rate cuts in 2026, while Rabobank has removed all expectations of UK rate cuts in 2026.

The core of this shock lies in Europe’s heavy reliance on energy imports. The US and Israel launched airstrikes against Iran last Saturday, and so far, there are no signs of the conflict easing. Brent crude oil has surged nearly 15% this week, nearing $84 per barrel, while West Texas Intermediate is approaching $77 per barrel. The sharp rise in energy prices has utterly shattered the previously widespread expectation that the ECB would maintain unchanged rates.

Rate cut expectations completely reversed, rate hike bets quietly heat up

Before the conflict broke out, there was broad consensus in the market that the ECB would keep rates unchanged this year. This expectation had pushed the implied volatility of the European rate market to a five-year low. In the UK, supported by a cooling labor market and weakening inflation, markets had generally expected the Bank of England to deliver a rate cut this month, which strongly supported demand for UK government bonds.

However, the outbreak of war quickly undermined these assumptions. According to Bloomberg, Morgan Stanley no longer expects the ECB to cut rates twice in 2026, citing significant uncertainty in the inflation outlook. Meanwhile, traders have begun pricing in the possibility of rate hikes. David Zahn, head of European fixed income at Franklin Templeton, stated that European inflation will most likely rise. While he does not expect rate hikes to be imminent, the timing for hikes "could be brought forward."

Rabobank has deleted all predictions for UK rate cuts in 2026, citing the negative supply shock to the UK from soaring gas and oil prices. Goldman Sachs has also delayed its expected timeline for the Bank of England’s next rate cut.

The Strait of Hormuz becomes the key variable; systemic risks should not be underestimated

The direction of the Strait of Hormuz will be the core variable that defines the intensity and duration of this crisis. Although Iran has not officially closed this globally crucial chokepoint for oil transportation, as the threat of war draws closer, the situation of an effective blockade is forming.

Elwin de Groot, head of macro strategy at Rabobank, warned in his latest report that if the Strait of Hormuz is blocked, the consequences will go far beyond soaring oil prices, triggering a "cascading, systemic global crisis." He pointed out that supply disruptions in energy would quickly transmit into petrochemicals, fertilizer, food production, metals, power grids, and semiconductor manufacturing, eventually threatening the fiscal foundations of nations and the stability of social order.

Euro under pressure, shadow of the 2022 energy crisis reemerges

The euro continues to come under pressure amid this round of safe haven flows. Bloomberg analysis points out that the eurozone's deep reliance on foreign energy forms a structural weakness for its currency—during the Russia-Ukraine conflict in 2022, the euro temporarily lost parity with the dollar, and the current situation is rapidly fueling market concerns about history repeating itself.

The fragility of market sentiment also reflects disappointment with central bank silence. Pooja Kumra, senior interest rate strategist at TD Bank, says part of the volatility is due to "the lack of any reassuring communication from central banks"; but in such a highly uncertain environment, policymakers also find it difficult to commit to any policy path in advance.

ECB Vice President Luis de Guindos admitted on Thursday that if the conflict persists, inflation expectations will begin to shift. He emphasized that although the eurozone economy demonstrated resilience before the outbreak, the future trajectory now depends entirely on the evolution of the geopolitical situation. During the session, the market briefly stabilized after Iran signaled a willingness to give up its uranium stockpile, but yields quickly rose again, showing that investors are gradually accepting the reality that the conflict may become protracted.

Risk warning and disclaimerThe market is risky, investment must be prudent. This article does not constitute individual investment advice and does not take into account the specific investment objectives, financial situation, or needs of individual users. Users should consider whether any opinions, views, or conclusions in this article fit their particular circumstances. Investments based on this article are at your own risk.