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- Investors have been frustrated by the lack of progress in reopening the Strait of Hormuz, which has pushed oil prices higher and stoked concerns about a supply shortage.
- In the UK, the 30-year gilt yield has increased almost 12% since the start of the Iran war, as political uncertainty weighs on the country’s outlook, in addition to the energy shock.
Sovereign bonds continued their sell-off this week amid worries that the energy shock from the Iran conflict could lead to a prolonged period of higher inflation.
Investors have been frustrated by the lack of progress in reopening the Strait of Hormuz – a vital chokepoint for global energy supplies – which has pushed crude prices higher and stoked concerns about a looming oil shortage. However, two Chinese supertankers exited the waterway on Wednesday, raising hopes of a partial reopening.
The yield on Japan’s 30-year sovereign debt shot up 11% between 8-19 May, before moderating a little towards the end of the week. Over the same period, the yield on the 30-year US treasury increased more than 5%1.
Figure 1: Pressure is building on longer end of the curve
“Pressure is building at the long end of the rate curve as markets come to terms with a more persistent and entrenched energy supply shock. What initially appeared to be a shift in inflation expectations is now feeding directly into realised inflation, reinforcing the view that central banks will need to keep policy tighter for longer to restore price stability,” says Mitch Reznick, Group Head of Fixed Income – London at Federated Hermes.
US inflation jumped to 3.8% in April – the highest level since May 2023 – as the impact of the war in Iran pushed up the cost of gasoline and groceries, adding to expectations that the US Federal Reserve will have to raise interest rates to combat rising prices.
The price of Brent crude was trading above US$100 a barrel on Thursday, and analysts expect global supply tightness to persist for months even if there is a breakthrough in negotiations between the US and Iran.
We’re seeing an unusually strong linkage between oil prices and global rates
Gilts under pressure
In the UK, gilts have endured a bruising sell-off, as political uncertainty weighs on the country’s outlook, in addition to the energy shock. Prime Minister Keir Starmer is widely expected to face a leadership challenge in the coming weeks.
The yield on the 30-year gilt has increased almost 12% since the start of the Iran war, and remains near its highest level since the late 1990s2.
“Rising borrowing costs are starting to expose fiscal vulnerabilities, particularly where debt levels are already elevated. As deficits widen and become more expensive to finance, that pressure is increasingly being expressed at the longer end of the curve,” Reznik says.
The UK’s debt-to-GDP ratio stood at 28% at the turn of the millennium, but has risen to close to 100% today (see Figure 2) on the back of the financial crisis and the Covid-19 pandemic. The Office for Budget Responsibility estimates that demographic pressures driven by the country’s ageing population could cause public debt to top 270% of GDP by the early 2070s, putting significant pressure on the future cost of borrowing.
Figure 2: UK public sector net debt (% of GDP)
“Markets appear to have priced in a significant amount of further tightening, with risks becoming more asymmetrical as expectations move beyond what central banks may ultimately deliver,” says John Sidawi, Senior Portfolio Manager for Fixed Income at Federated Hermes.
“Much will depend on how developments in the Middle East evolve. Any escalation would likely push yields higher and undermine valuation arguments, while stabilisation could bring investors closer to re-engaging as bonds move further into value territory.”
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