Over a month has passed since the US and Israel launched missile strikes on Iran, followed shortly after by Iranian retaliatory strikes and the closure of the all-important oil export waterway, the Strait of Hormuz. Amid the human tragedy, financial markets have experienced a rollercoaster ride. Buoyed by the recent ceasefire and US-Iran talks in Pakistan, equity, credit and forex markets have largely retraced back to pre-war levels. Bond markets have not. In our Global Aggregate Strategy, we believe the interest rate hikes priced in by European bond markets represent attractive value.

Value has been created in the front-end of euro and UK bond markets

The intense US-Iran negotiations are producing rolling headlines that may quickly date this note.  But as of 15 April, the market was pricing two rate hikes from the European Central Bank (ECB) and about one and a half hikes from the Bank of England (BoE) in 2026. By contrast, at the end of February, the market was pricing a small chance of a cut from the ECB and two cuts from the BoE.

The market switched to pricing a hawkish interest rate outlook largely because of concerns that central banks might respond to this oil shock by prioritising the anchoring of inflation expectations. The market is not actually overly concerned about long-term inflation or inflation expectations themselves. Exhibit 2 shows that the market’s expected inflation rate over the next 12 months jumped in March on the back of higher wholesale energy prices. But longer-term inflation expectations, represented by the five-year inflation swap starting five years forward, barely changed.

Certainty about rate hikes contrasts with a more optimistic energy outlook in other markets

Despite the certainty of market pricing, rate hikes from the ECB and BoE are far from obvious. Not least because it’s not clear that the stress in energy markets will persist. The closure of the Strait of Hormuz has already created significant economic uncertainty and political pressure in the US, so it is possible that the crisis continues to de-escalate, and oil starts flowing relatively quickly, lowering inflation forecasts for the next year. This optimistic outlook is already evident in other markets, with equities, credit spreads and forex markets largely retracing to pre-war levels. Bond markets are the exception, continuing to offer a risk premia for the uncertain geopolitical and energy outlook.

2026’s economic pre-conditions are very different than 2022

Even with oil prices at around $100 per barrel, there is a strong probability that inflation expectations remain low. The bond bears frequently cite the 2022 Russian invasion of Ukraine as the case study for how an energy shock might de-anchor European inflation expectations. But the shock to European energy costs is much lower today. The ECB’s economic forecasts model an energy shock based on a synthetic energy index with an estimated weight of 70% for natural gas and 30% for crude oil (source: J.P. Morgan Asset Management, ECB December 2025 economic projections). While the spike in oil prices is similar to 2022, the spike in natural gas prices this time round (up 31% from pre-war levels) is a fraction of that seen in 2022, when prices peaked 367% higher (source: Bloomberg Netherlands TTF Natural Gas 1 month forward contract, 21 February 2022 to 26 August 2022, and 27 February 2026 to 15 April 2026).

The prior economic conditions are also very different. Inflation, for example, is much lower today. Euro inflation was 1.9% in February 2026, vs. 5.9% in February 2022, while today’s “sticky” 3% UK inflation (February 2026) contrasts with an eye-watering 6.2% in February 2022. And today’s looser labour markets also reduce the odds of second-round inflation effects from a wage-price spiral: the UK’s 5.2% unemployment rate (January 2026) is now closer to the 2020 Covid peak than the 3.6% low in July 2022.

Finally, macro policy settings are much tighter today. Back in February 2022 interest rates were still around zero, with fiscal deficits running at extraordinary Covid levels. Today, interest rates are around neutral to slightly restrictive, while outside Germany, European governments are trying to cut deficits with tax hikes and spending cuts.

These factors suggest that the pass-through from energy to core inflation and wages will be much lower in 2026 than in 2022. Nevertheless, the hit to real disposable incomes, as higher energy prices squeeze consumer purchasing power, will still likely manifest as a slowdown in consumption growth.

What could go wrong?

It would be imprudent to simply assume that the recent conflict continues to de-escalate. Investors should not dismiss the risk that talks break down and the energy crisis intensifies. But by pricing rate hikes, European bond markets already price a material risk of this scenario. In short, the downside risks from greater geopolitical conflict appear much less than the potential upside.

Interest rates tend to be mean-reverting, but markets are not pricing a return to more neutral rates should central banks hike in 2026.  A 50 basis points hiking cycle would push interest rates into restrictive territory. Unless offset by substantial fiscal stimulus, this rate increase, together with the squeeze on disposable income, could further depress growth. Therefore, as the energy shock falls out of the year-on-year inflation rates, in 2027, European central banks could come under increased pressure to address the growth shock. But, while markets are pricing hikes for 2026, they have not accounted for the chance that central banks may have to correct course in late 2027/early 2028 by cutting rates.

Investors should consider tilting portfolios towards European fixed income

European bond markets have swung 180 degrees from pricing rate cuts to a rate hike cycle. This about-turn reflects the risk that European central banks may raise rates to be sure that the energy shock doesn’t lift inflation expectations. But economic pre-conditions are very different from 2022.

As a result, we believe European bond markets now offer investors attractive risk premia. They are already pricing in a lot of the inflation risks from the current Middle East conflict, which should mitigate risks for investors if the energy crisis intensifies. At the same time, they offer attractive potential positive returns should the conflict continue to de-escalate, should softer labour markets prevent second round effects, or if downside growth risks outweigh the inflation shock from higher energy prices.  Should oil prices return to pre-conflict levels we believe European bond markets could rally to price the European Central Bank on hold and a potential cut from the Bank of England in late 2026.