Union Connect: Iran Conflict Keeps Central Banks and Bond Markets on Edge

Christian Kopf
Head of Fixed Income at Union Investment

The ongoing conflict in the Middle East continues to unsettle capital markets. Alongside heightened volatility in risk assets, bond markets are experiencing rising yields. Inflation concerns have led the market to price in substantial interest rate increases by the European Central Bank (ECB). Experts at Union Investment remain confident in their base scenario, expecting a prompt resolution of the conflict with limited impact.

Approximately four weeks after the outbreak of hostilities, peace efforts are underway, though their success remained uncertain as of the editorial deadline (Monday, 30 March), due to conflicting statements. Consequently, capital markets have been jittery, oscillating between fears of further escalation and hopes for a swift cessation of fighting. After US President Donald Trump postponed an ultimatum to reopen the Strait of Hormuz until Easter Monday, risk assets such as equities showed some calming, albeit with continued volatility. Bond markets, particularly at the short end, weakened further, causing the yield curve to flatten. Longer maturities also suffered losses: yields on ten-year German Bunds temporarily rose to 3.13%, the highest level since June 2011. US Treasuries also saw yield increases, though the flattening of the curve was less pronounced. The rise in yields is primarily driven by significantly changed inflation expectations since the conflict began. Market participants now price in nearly four 25-basis-point ECB rate hikes over the next twelve months. Conversely, the Federal Reserve’s anticipated two rate cuts have been fully priced in.

The market now expects substantial ECB interest rate hikes

Central Bank Expectations Have Shifted

Source: Bloomberg, LSEG, Union Investment. As at 27 March 2026. * At year-end, ** ICE BofA Euro Corporate Index.

It is clear that the longer the conflict persists and the Strait of Hormuz remains partially closed, the greater the impact on inflation and growth will be. Our investment strategists and economists continue to regard a swift end to hostilities as the base case, accompanied by a gradual normalisation in commodity markets. President Trump is likely to seek a viable path to ending the conflict, as indicated by the extension of the 48-hour deadline to Iran and informal exchanges between the US and Iran, including a proposed 15-point plan. However, we also consider a risk scenario involving further escalation possible, though less likely.

Looking Through a Prompt End to the Conflict?

Due to the prolonged partial closure of the Strait of Hormuz and the resulting rise in energy and oil product prices, we expect a temporary marked increase in inflation. In both the eurozone and the US, inflation rates in 2026 are projected to be around 40 basis points higher, with GDP growth correspondingly dampened by approximately 10 basis points. This assumes Brent crude oil prices will fall below USD 100 per barrel by the end of April and continue to decline throughout the year. Such a short-term supply and price shock should allow the ECB to “look through” the inflation spike, as underlying inflation is expected to remain stable. Our base scenario also foresees no significant growth setbacks, as pent-up investments are likely to be realised.

At a conference in Frankfurt on 25 March, ECB President Christine Lagarde emphasised that rate hikes could be decided at any Governing Council meeting, including potentially in April. However, she also made clear that a rate increase was not yet a foregone conclusion, contrary to market expectations. The ECB intends to keep its options open in a rapidly changing environment. From our perspective, Lagarde’s stance reflects a preference for de-escalation and prudence. The central bank is monitoring risks closely and will deploy its instruments gradually, depending on how the shock evolves. Lagarde noted that the current situation should not be viewed solely through the lens of the 2022 energy shock. Several factors suggest that rising energy prices may have a less pronounced effect on inflation this time, including lower pent-up demand, reduced labour shortages, and a different monetary policy starting point. Her remarks confirm our view that an April rate hike is by no means certain and not the most likely scenario. Especially if the Iran conflict ends soon, we do not expect an ECB reaction until signs of second-round effects become clearer.

We remain sceptical of market expectations for a rapid rate rise. Given the higher inflation, however, we anticipate higher yield levels by the end of June and September for two-year German Bunds (2.25%, currently 2.69%) and two-year US Treasuries (3.75%, currently 3.89%). Swap spreads for German Bunds are expected tp remain temporarily positive but will not rise as sharply as during the 2022 rate cycle, as increased issuance by the German government has eased scarcity. We also expect German Bunds to continue not behaving as a "safe haven," maintaining their positive correlation with risk assets such as equities, thus offering limited diversification benefits.

Source: Union Investment, All information, explanations and illustrations are as at 30 March 2026, unless otherwise stated