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European government bonds reversed course on Thursday, moving higher after plunging during the previous session, as a fragile Middle East ceasefire keeps markets on edge.
Bond traders are grappling with unusually high levels of volatility, which is clouding the outlook for interest rate policies at the Bank of England and European Central Bank.
Yields on 10-year Gilts — the benchmark for U.K. government debt — rose more than 6 basis points to 4.775% on Thursday, after tumbling 21 basis points a day earlier. The 2-year Gilt yield climbed 7 basis points to 4.245%, having dropped 25 basis points in the previous session.
German bunds followed a similar pattern. The 10-year Bund yield rose almost 5 basis points to 2.9886%, after falling nearly 17 basis points on Wednesday. Meanwhile, 2-year Bund yields — which shed 28 basis points in the prior session — rebounded 6 basis points to 2.5549%.
Bond yields and prices move in opposite directions, and one basis point equals 0.01%.
Inflation risks weigh
Markets have whipsawed since hostilities between the U.S. and its allies and Iran began on Feb. 28. Borrowing costs across multiple European economies have touched multi-decade highs in recent weeks, with elevated oil prices driving inflationary fears and complicating how investors assess the future path of interest rates.
Laura Cooper, global investment strategist and head of macro credit at Nuveen, said volatility has become "the new norm," as traders look to distinguish signal from noise. "Investors cannot tune out every headline but also can't trade every one either," Cooper said.
U.K. 10-Year Gilts.
She added that the resumption of oil and gas shipping flows through the Strait of Hormuz will be crucial in limiting lasting economic damage, describing ongoing disruptions as "not an aberration" but an "expression" of a shifting geopolitical order.
"The developments do little to contain near-term price pressures with a risk premium still warranted in crude oil and evidence of supply chain disruptions building, the latter of which will take time to resolve," she told CNBC via email.
"Inflation risks could limit the rally of long-end bonds until there is evidence of growth destruction, and we hold greater conviction in steeper curves…. Positioning has skewed shorter in duration, with curve steepeners and inflation protection increasingly preferred over outright rate bets."
Dan Coatsworth, head of markets at AJ Bell, said rate hikes remain likely — albeit potentially fewer than expected before Tuesday night's ceasefire announcement.
"Any sign of oil prices going back up could lead to another sell-off on the bond market," Coatsworth told CNBC via email. "We're in a tricky situation as markets now appear to be showing widespread optimism for the Iran crisis to be nearing conclusion, yet it's far too early to take that view."
Brent crude.
Global oil prices jumped again Thursday, but remain off their recent highs. International benchmark Brent crude was up more than 3% to $97.60 a barrel, while in the U.S., West Texas Intermediate prices reached $98.53, a 4.3% increase.
Higher-for-longer oil and gas costs are expected to hit Europe, a net importer of energy, harder than other regions.
Policymakers are now closely monitoring how energy costs feed through into the broader economy, through inflation expectations, wages and core price measures, said Nicholas Brooks, head of economic and investment research at ICG.
Investors brace for rate hikes
Markets are now pricing 25 basis points worth of Bank of England interest rate hikes this year, down from 50 basis points before the ceasefire. Two hikes are expected from the ECB this year, reflecting the bank's leeway to increase rates following the sustained rate cuts from their mid-2024 peak.
Brooks said: "Although markets are still pricing in rate hikes, given more slack in both the U.K. and Eurozone economies compared to the last bout of inflation in 2022 we think it would be prudent for the central banks to take a wait-and-see approach to policy, rather than react prematurely."
German 10-Year Bunds.
Matthew Amis, investment director of rates management at Aberdeen Investments, called the ceasefire "undoubtedly good news," but warned "this is far from over."
European and U.K. government bonds now offer some value after being hit by the sharp reversal in sentiment since the conflict began, Amis said. But any move lower in yields is unlikely to be smooth, he added, as markets must now navigate a "headline-heavy" period in the weeks ahead.
"Yields can continue to move lower, however markets will remain on high alert," Amis said. "We tentatively added risk back over the last week or so as we believed markets had priced too many hikes. We are happy to hold that here — if the positive news flow continues, hikes can continue to be priced out of both the U.K. and EU."
