Key Takeaways
- The war in Iran has pushed yields higher and government bond prices lower, especially for short-term maturities.
- Bond markets are pricing in potential interest rate hikes, whereas before the Middle East crisis, investors had expected stable rates from the ECB.
- According to bond fund managers, the market reaction has been excessive, and government bond yields could fall in the second quarter if geopolitical tensions ease.
The war in Iran drastically altered the outlook for interest rates at major global central banks, including the ECB, in March. Bond markets reacted negatively, with government bond prices falling and yields rising, particularly for short- and medium-term maturities. Despite the announcement of a two-week ceasefire in the Iran war, the second quarter of 2026 begins amid uncertainty over the outcome of the conflict in the Middle East, and growing fears of stagflation—a combination of high inflation and economic stagnation.
For eurozone government bonds, the first quarter closed with a 1.21% decline, largely driven by the US and Israeli attack on Iran on Feb. 28. Prior to that, the Morningstar Eurozone Treasury Bond Index had risen by 1.80%. In March alone, the decline was 2.91%, marking the worst month since December 2022, when it fell by 4.40%.
This was the worst quarterly performance since the first quarter of 2025, when the Eurozone government bond index lost 1.72% due to heavy selling in January and March, following announcements of increased defense spending by European countries and a large public spending package in Germany.
The European Bond Market’s Expectations Have Changed Radically
“Monetary policy expectations are radically different from those priced in at the end of February,” says Massimo Spagnol, senior fixed income portfolio manager at Generali Asset Management. Markets have come to expect three or four 0.25 percentage point hikes by the European Central Bank in 2026, whereas until the end of February they expected no action.
At its meeting on March 19, the ECB left its benchmark rate at 2%, acknowledging, however, that the war in the Middle East “has made the outlook considerably more uncertain, creating upside risks to inflation and downside risks to economic growth.”
Do Government Bonds Point to a Stagflation Scenario?
The sharp correction in interest rate expectations in the eurozone has led to a rise in bond yields, particularly for short- and medium-term bonds, driven by fears of inflationary spikes. Movements in the eurozone government bond market have also raised the prospect of stagflation for two reasons.
First, the market views the greater increase in short-term bond yields compared to long-term yields as an indicator of stagflation. In technical jargon, this is referred to as “yield curve flattening.” Typically, long-term government bonds offer higher yields than short-term ones.
Second, the positive correlation between falling stock prices and falling bond prices. Under normal circumstances, stocks and bonds tend to move in opposite directions. Stocks and bonds moving in tandem have been a phenomenon accompanying past stagflationary periods.
Are Bond Markets Wrong About the ECB’s Future Moves?
According to Andrea Campisi, senior investment manager at Pictet Asset Management, the “market has been very reactive” to the shock in oil and gas prices, still fresh from the 2022 energy crisis caused by Russia’s invasion of Ukraine. “For the current year, four rate hikes by the ECB have also been priced in. This tightening seems unrealistic to us in terms of both magnitude and speed,” says Campisi, who believes there could be “no more than two” interest rate rises.
Investors are therefore entering the second quarter wondering whether the markets might be wrong about the future moves of the ECB and other central banks. Jeffrey Cleveland, chief economist at Payden & Rygel, is “skeptical” about current bond valuations, because the current energy shock represents a “supply shock” due to the blockade of the Strait of Hormuz and damage to gas facilities in Qatar. Central banks generally tend “not to counter these types of shocks with restrictive measures,” says Cleveland.
Will the ECB Raise Rates in Q2?
On the other hand, ECB President Christine Lagarde has reiterated that monetary policy is not predetermined and will depend on the duration of the shock. The central bank will have to take into account so-called “second-round effects” on prices and wages—that is, whether rising energy prices will spill over into the prices of goods and services through, for example, higher transportation costs.
Preliminary estimates of inflation in the eurozone showed a 2.5% increase in March, compared to 1.9% in February, well above the 2% target set by the central bank. The main driver was energy prices, which rose by 4.9%, while other components such as services saw a slowdown.
“If the rise remains confined mainly to energy, the ECB might even choose to look beyond short-term volatility, keeping interest rates unchanged over the next six to nine months,” says Filippo Diodovich, senior market strategist at IG Italia. If, on the other hand, there are further escalations of the war in the Middle East, with new increases in energy costs that also extended to core inflation, the ECB could be forced to raise rates, with June being the most likely scenario. A possible upward adjustment in April appears less likely.
Will Government Bond Yields Rise in the Second Quarter?
Faced with shifting interest rate expectations, the eurozone government bond market reacted immediately with a rise in short-term bond yields, which are more sensitive to a defensive response from the ECB that prioritizes inflation control and financial stability over growth stimulus. If energy prices were to stabilize in the coming months, these yields “appear high,” according to the fixed-income team at J.P. Morgan Asset Management, which adds, that in more severe scenarios, yields could rise further.
Bond markets are also keeping an eye on fiscal policies. Early signals from Europe “suggest that fiscal support will be temporary, targeted, and specific, and will not take the form of broad-based demand-stimulus measures, such as those implemented in 2022,” the team at J.P. Morgan says. But if governments were to roll out more substantial measures, “this would in all likelihood lead to an increase in yields in the middle of the curve, while a more cautious fiscal approach would result in greater upward pressure on short-term yields.”
European Fixed Income Managers Choose a Cautious Approach for Q2
Investors in eurozone government bonds are maintaining a cautious approach, recognizing that, on the one hand, the market may have reacted too sharply; on the other, that the risks of stagflation could intensify.
“To address this situation, the bond portfolio has been positioned neutrally relative to the benchmark market, both in terms of interest rate risk and credit risk. Furthermore, the level of diversification has been increased to mitigate the negative impacts of volatility,” says Spagnol of Generali Asset Management.
Due to the weak growth outlook and excessive expectations regarding ECB rate hikes, Campisi of Pictet Asset Management says he has “focused on the short end of the curve,” which is more sensitive to a potential shift in monetary policy. “We have also partially reduced risky assets to better balance the portfolio.”
Sam Vereecke, head of fixed income investments at DPAM, has reduced exposure to country credit risk and duration. “The memory of the recent surge in inflation also increases the risk that markets will price in potential secondary effects before they materialize.”
Fewer Italian Government Bonds in Fixed Income Portfolios
Peripheral government bonds, particularly Italian BTPs, have been hit hardest by the effects of the war in the Middle East, due to Italy’s dependence on foreign energy supplies. The spread between the 10-year BTP and the 10-year German bund rose from about 60 basis points to over 100 bps in March, before closing the first quarter at 90.99 bps. A widening of the spread indicates that investors are demanding a higher yield to compensate for the risk of investing in Italian debt compared to German debt. As of March 31, the 10-year BTP yields 3.92% versus 3.01% for the German Bund.
Some managers have reduced their exposure to Italian government bonds to limit the impact of market repricing. “Exposure is currently neutral,” says Spagnol of Generali Asset Management. “Although absolute and relative levels are very attractive, the degree of uncertainty is very high, and a further widening of the spread cannot be ruled out. The current reference range is 80–100 basis points.”
Vereecke of DPAM also says that “Italian government bonds have shifted from overweight to underweight” in his portfolio.
