Prospect of prolonged Iran conflict ignites inflation concerns
The US and Israeli military strikes against Iran have reverberated through financial markets in recent days, reigniting concerns over inflation and causing investors to dump popular bond wagers.
Government bond yields climbed sharply amid fears that a prolonged conflict will disrupt global energy markets and cause inflation to accelerate again, forcing central banks to reverse course and start tightening monetary policy.
Investors have shed assets that look most vulnerable to higher interest rates, including Italian and French government bonds that many had held as carry trades. Italy is one of the countries most exposed to natural gas price rises and the yield on two-year Italian government bonds has jumped more than 30bp since the outbreak of the conflict – to about 2.35%, its highest level in around a year.
Short-dated German, French and UK bond yields have also rocketed as investors anticipate a change of tack from central banks that, until recently, had looked more likely to cut rates than to raise them.
“Consensus trades, like being long Italy and France to gain carry on those bonds, are really being tested now,” said Jorge Garayo, head of inflation strategy at Societe Generale, who said the unwinding of carry trades was exacerbating price swings.
“These are remarkable moves and help to mechanically boost inflation expectations higher in the market,” he said.
Gas and oil prices across Europe and Asia surged to their highest levels since Russia’s full invasion of Ukraine in 2022 after Tehran lashed out at the broader Gulf region in retaliation for US and Israeli missile strikes that killed Iran’s supreme leader. Concerns over another energy crisis have increased the probability, in investors’ eyes at least, that global central banks will need to pivot to interest rate hikes to dampen inflation.
Swiss private bank UBP said oil prices reaching US$100 a barrel because of reduced supply could add 0.2 percentage points to global inflation, while hitting US$120 could trigger a recession. Brent crude prices hit more than US$90 on Friday, up from US$60 in early 2026.
Jane Foley, senior foreign exchange strategist at Rabobank, said market prices suggest central banks are now expected to raise interest rates in eight of the G-10 countries over the coming year. That includes a 10bp hike by the end of 2026 from the European Central Bank, according to analysis by Natixis CIB.
“A supply shock coupled with an inflation shock that has the potential to slow economic growth is the worst situation for central banks as it creates conflicting signals on whether to raise interest rates or not,” said Benoit Gerard, interest rates strategist at Natixis CIB. “Central banks will be monitoring inflation expectations … very closely.”
Inflation hedging
So far, at least, inflation expectations have remained stable. The euro five-year, five-year inflation swap – a gauge of medium-term euro inflation that represents the market's expectation of five-year average inflation, starting in five years' time – has inched up slightly, but remains closely anchored to the ECB’s target of 2%.
And while investors are worried that inflation could trend upwards in a protracted war with Iran, such fears haven’t yet fed into a marked rise in hedging activity.
Yvon Pilchen, head of swaps and inflation derivatives trading at Natixis CIB, said there was increased buying of short-term inflation protection early in the week following the jump in energy prices. However, he said the market reaction is very different to what followed Russia’s invasion of Ukraine in 2022.
“Energy prices are much more stable and Europe is now much less dependent on imported energy, so I don’t think we’re likely to see a repeat of what happened in 2022,” he said.
Jackie Bowie, head of EMEA at hedging advisory firm Chatham Financial, said clients who are most active in hedging inflation tend to take a much longer-term view and therefore aren't as concerned about short-term moves. That includes “real asset” investors, who typically put long-term inflation hedges in place when completing an underlying transaction.
“Inflation hedging tends to be much less reactive,” Bowie said. “It’s not like the [foreign exchange] market where any market moves will cause people to react quite quickly.”
SG’s Garayo said the moves in inflation markets have been largely contained. “It’s on the high side at the front end of the curve, but it’s not like the market is dislocated or moving dramatically higher,” he said.
Investors are still hoping the conflict – and any impact on energy prices and inflation – will prove to be short-lived, despite the Trump administration refusing to rule out a months-long campaign. In the meantime, many are taking a wait-and-see approach before pulling the trigger on hedging transactions.
“From what we’ve seen, the clients who were putting rates hedges in place last week are pausing that activity as they’re waiting to see whether this initial market reaction calms down over the next few days, and therefore whether the cost of hedging becomes cheaper, which will be determined by how long this conflict lasts,” said Bowie.
