Key Takeaways
- Markets have begun to price in an interest rate hike by the ECB, rather than a cut, in 2026 as the Iran war drives inflation fears.
- The positive correlation between equities and government bonds indicates that markets are once again considering a stagflation scenario, but with a low probability of it occurring.
- Shorter-term bonds saw more significant increases than longer-term ones, that indicates that markets are beginning to price in a stagflation scenario.
The specter of stagflation is rearing its head again in Europe due to the war in Iran. After a black Monday for financial markets, with oil prices rising and stock markets falling, markets regained momentum on Tuesday, following statements by US President Donald Trump that the war could end “very soon.” However, fears that something has broken in the gears of the European economy remain high.
Stagflation, which is a combination of stagnation and inflation, is the risk that most concerns economists and investors. “The positive correlation between stocks and government bonds [...] brings the stagflation scenario back to the surface,” says Luca Simoncelli, investment strategist at Invesco.
Since the US and Israeli attack on Iran on Feb. 28, stock markets have been highly volatile, with the VIX index—also known as the “fear index”—reaching its highest levels since April 2025. In the bond markets, on the other hand, government bond yields have risen, and prices have fallen as a result, as the two variables move in opposite directions.
In addition, shorter-term securities saw more significant increases than longer-term ones, a phenomenon known as “curve flattening” that indicates that markets are beginning to price in a stagflation scenario. The 10-year German bund, taken as a benchmark for the eurozone, rose by 0.22 percentage points to 2.86%, while the 2-year German bund rose by 0.32 percentage points to 2.31% between the start of hostilities and March 9.
What Is the Worst-Case Economic Scenario for Europe?
In Europe, stagflation is a more imminent risk than in other regions because of its vulnerability not just to oil prices, but also to skyrocketing gas prices, as markets remain skeptical about energy supplies quickly returning to normal.
“The time factor is central to both energy price dynamics and the likelihood of stagflation becoming a reality,” says Invesco’s Simoncelli.
Bond markets are sending mixed signals. On the one hand, expected inflation discounted by inflation-linked securities shows modest increases, while on the other hand, one-year swap contracts have moved upward. Both inflation-linked bonds and inflation swap are used as an indicator of market expectations, with the latter preferred to monitor the inflation expectations in the short-medium term.
In less technical terms, this means that inflation is expected to rise in the short term, while there is uncertainty about the direction it will take in the long term.
“If oil prices [were to] remain stable above USD 100 per barrel and perhaps around USD 110-120 for weeks or months, the impact on inflation and inflation expectations would be significant,” says Filippo Diodovich, senior market strategist at IG Italia.
Add to this the surge in gas prices, and the energy shock could reduce real income and slow growth, while simultaneously pushing up inflation. “This is exactly the mechanism that gives rise to fears of stagflation,” says Diodovich.
Why Stagflation in Europe Is Still Unlikely
However, the worst-case scenario for Europe, with sharply rising inflation and slowing economic growth, does not appear to be the most likely at the moment.
“It’s not our central scenario,” says Mike Coop, chief investment officer EMEA at Morningstar Wealth. “We assign it a probability closer to 20%-25%, because the supply disruption could quickly come to an end and the war has not been going for a long time.”
Coop also points out that the seasonal peak in demand for energy products from major importers in the northern hemisphere of Europe, China, Japan and India is coming to an end.
According to Julius Baer research, the likelihood of a full-blown oil crisis has a probability below 5%, while a “short and intense” scenario, with Brent crude oil between USD 80 and USD 90 per barrel and European gas (TTF) between EUR 40 and EUR 50 per MWh, has a probability greater than 60%.
It’s Not Another Energy Crisis Like 2022
For Morningstar DBRS, the scenario “may be different this time” than when Russia invaded Ukraine in 2022, because the price shock appears less “severe” and the eurozone is experiencing low inflation and low interest rates.
“It is much too early to have a definitive view on how this energy shock will affect economic growth and price developments in Europe,” says Jason Graffam, senior vice president at Morningstar DBRS. He says recent developments - such as the possibility that the US may disengage earlier than previously assumed - support the idea that this time is different. This makes the inflation passthrough to Europe likely to be more muted in 2026 than in 2022.
Is the ECB Heading for an Interest Rate Hike?
Markets expect the European Central Bank to keep its benchmark rates unchanged at 2% at its March 19 meeting, but the probability of a rise in 2026 is increasing.
In a situation that remains highly uncertain, expectations regarding the ECB’s next monetary policy moves are changing, with markets increasingly less confident about a possible interest rate cut.
“The market is pricing in almost two rate hikes by the end of the year,” Intermonte’s advisory and management team writes in a note, adding that “Bundesbank President Joachim Nagel has emphasized that the impact of the conflict on inflation is currently more worrying than that on growth, while acknowledging that high volatility makes it difficult to make definitive assessments.”
