Key facts
- UK 10-year government bond yields surpassed five percent for the third time since the Iran war began.
- The collapse of the Iran-US ceasefire led to renewed strikes and a surge in oil prices.
- The Strait of Hormuz was blockaded by the US, impacting shipping.
- Higher inflation and stubborn price rises are driving up bond yields.
- Traders are pricing in a Bank of England interest rate hike by year-end.
- The market also anticipates a potential Federal Reserve rate hike this month.
The UK's borrowing costs have surged past five percent for the 10-year government bond, a level not seen since the onset of the Iran war, as tensions between Iran and the US escalate. The fragile ceasefire shattered, leading to renewed strikes and a significant jump in oil prices. This geopolitical instability has caused government bond yields to rise across developed economies, with the UK particularly exposed due to its reliance on imported energy and persistent inflation.
Higher inflation typically compels traders to demand higher interest rates for holding bonds, as rising prices can erode real returns. Investors also anticipate central bank interest rates remaining elevated for longer when inflation is stubborn. Daniel Mahoney, senior UK economist at Handelsbanken, noted the volatility of UK gilts since the start of the Iran War, expecting them to remain the highest in the G7.
The sell-off has also impacted shorter-dated bonds, with the two-year gilt yield climbing above 4.5 percent for the first time since mid-May. This has led traders to increase their bets on the Bank of England raising its central interest rate at its next meeting on July 30. Kathleen Brooks, research director at XTB, stated that the energy price spike means markets are pricing in more interest rate hikes, with a full hike expected from the Bank of England by year-end.
The market also anticipates the Federal Reserve potentially raising interest rates this year, with markets implying a 40 percent chance of a hike at their upcoming meeting. The sharp rise in borrowing costs presents a significant fiscal challenge for incoming Prime Minister Andy Burnham, who is set to take office soon. The previous 60-day ceasefire had eased pressure on public finances.