London equities fell sharply as gilt yields and the Iran conflict combined to push UK borrowing costs to levels that have rattled investors and called into question the path of interest rates. Two-year gilt yields, which reflect short-term rate expectations, jumped over 4.5 per cent, compounding pressure on households and businesses already dealing with elevated inflation.
According to Reuters, the two-year gilt yield soared by as much as 37 basis points in early trade to 4.239%, a move that caught many in the market off guard given how quickly sentiment has deteriorated since hostilities in the Middle East resumed at the weekend.
Rate cut hopes evaporate as gilt yields and Iran conflict deepen
The speed of that repricing has been felt acutely in rate expectations. Since the conflict broke out, market bets for the Bank of England to cut rates when its Monetary Policy Committee (MPC) next met fell from 80% to just 30%, according to The Guardian. That is a dramatic reversal in a matter of days and illustrates how quickly an overseas military escalation can reshape domestic financial conditions.
The MPC ultimately left its main rate unchanged at 3.75% when it met on 19 March, according to the UK Parliament House of Commons Library. However, the committee had warned in August that it would likely raise rates should a conflict between Iran and the US re-emerge. That condition now appears, to many analysts, to have been met.
City analysts have pointed to the UK’s particular vulnerability to inflation shocks as the reason gilt yields are bearing so much of the strain. Unlike economies with greater energy self-sufficiency, the UK is exposed to commodity price swings that feed quickly through to consumer prices and, in turn, to the Bank’s policy calculus.
Oil price threat and an inflation worst case
Brent crude held firm around $95 per barrel after rising for three consecutive sessions, with investors spooked by the renewal of hostilities and weak efforts to reopen the Strait of Hormuz. Should prices climb further, the consequences for UK inflation could be severe. The BBC reports that, in a worst-case scenario where oil reaches $100 a barrel, the Bank now projects inflation could reach 3.2% in 2026. The report puts the outer edge of the Bank’s worst-case thinking at four per cent (double its two per cent target) should the conflict prove prolonged and disruptive.
Economists broadly predict inflation in the UK will creep above three per cent in the coming months before easing back to two per cent. But those forecasts rest heavily on hostilities simmering out, and there is little sign of that yet.
RBC Capital Markets analysts said they struggled to see current interest rate pricing ‘getting realised’, though they identified risks for ‘further weakness’. Their caution is widely shared. US Treasuries have also been sold off at pace after Federal Reserve chair Kevin Warsh signalled that rate hikes could be on the horizon in the United States, pulling global yields higher in sympathy with American markets.
The feedback loop is self-reinforcing. Higher gilt yields lift the cost of government borrowing, squeeze mortgage rates, and damp business investment, all at a moment when the economy can ill afford additional headwinds. The pound has also come under pressure alongside gilts, adding an imported inflation dimension to a problem that already has several domestic drivers.
For business owners and executives assessing their financing costs, the near-term picture is uncomfortable. The MPC’s decision to hold at 3.75% on 19 March offered no immediate relief on rates, and markets are no longer pricing in a cut at any near-term meeting. With the Commons Library confirming the hold, the next question is whether the conflict, and the oil price it is stoking, forces the committee’s hand in the other direction before the year is out.
