8u]l)i1frb(zeg8zcwe87hl4_media_dl_1.png Bloomberg

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(Bloomberg) — European bonds extended losses as traders weighed the possibility of a prolonged conflict in the Middle East, a scenario the European Central Bank’s chief economist warned would be stagflationary. 

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Yields on shorter-dated German bonds — more sensitive to changes in monetary policy — rose faster than longer-dated peers, with two-year yields up as much as eight basis points to 2.17%. Money markets moved to price around a one-in-three chance that the ECB will hike interest rates by the end of the year. 

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Euro-area debt underperformed Treasuries, with US yields up around four basis points. Europe is seen as particularly vulnerable to an escalation in the war, given the region imports almost all of its oil and most of its natural gas, leaving it more exposed than the US, a net energy exporter. 

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European natural gas prices are up more than 60% since Friday’s close, volatility not seen since the energy crisis in 2022, after shipments were halted from the world’s largest LNG export plant in Qatar.

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“European bonds have now woken up, because LNG went down yesterday and the gas-price link came through,” said Salman Ahmed, global head of macro and strategic asset allocation at Fidelity International on BTV. “This is not a war where bonds will be your stabilizers.” 

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Ahmed has been recommending clients look to gold for protection, instead of sovereign debt. Investors around the world have been selling government bonds as the ramp up in oil prices rekindles inflation concerns. 

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US President Donald Trump has vowed to do “whatever it takes” in Iran and indicated his readiness to allow the conflict to extend beyond the four to five weeks he had initially projected. ECB Chief Economist Philip Lane said a prolonged war in the Middle East could cause a “substantial spike” in energy-driven inflation and a sharp drop in output.

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Traders sharply pared bets on Bank of England interest-rate cuts, to fully price out the prospect of a second quarter-point reduction this year. Yields on two-year UK debt rose as much as 12 basis points to 3.76%.

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—With assistance from James Hirai.

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