It's a complete reversal for interest rates. In less than two weeks, the conflict in the Middle East and its inflationary consequences have pushed the German 10-year yield – the European benchmark – to its highest level since late 2023. A few more basis points would even take us back to a 15-year high.
Source: MarketScreener
On the short end of the curve, the rebound is even more significant: approximately 45bp in less than two weeks on the German 2-year. The market is now pricing in two quarter-point rate hikes by the ECB by the end of the year. Before the outbreak of the conflict in Iran, the central scenario was a status quo in 2026. And the risk was rather that of an additional rate cut, given inflation forecasts below the target this year.
The ECB meets next week, but it is still far too early to take action. Investors currently expect a rate hike in July. The ECB is also due to publish its new economic projections, but these will not fully incorporate the impacts of the war in the Middle East.
While yields have risen sharply, spreads have also followed suit. The yield gap between the Bund and the Italian BTP reached 84bp this morning. A brutal rise which, however, does not erase the decline of recent years. The spread went from 250bp at the time of Giorgia Meloni’s election in 2022 to a low of 53.5bp in mid-January, a level not seen since August 2008. This comes even as the German and Italian economies have experienced very different dynamics in recent years.
The rise in rates is also explained by expectations of higher fiscal spending by governments to mitigate the effects of the energy shock. Such measures were implemented in 2022 to deal with the consequences of Russia’s invasion of Ukraine.
