Tightening up
Posted 11 September 2026
More bond pain hindered stock markets this week. Despite stable US core inflation (2.4% year-on-year for August), Middle East re-escalation pushed oil prices above $100 per barrel and gas sharply higher. That forced the European Central Bank to raise interest rates for the second time this year. The fear of substantially higher short-term rates bumped government bond yields higher again. Equities remained relatively calm – helped by strong earnings from US tech firm Oracle – but rate-sensitive sectors outside of tech struggled.
The global energy crisis looks unlikely to resolve soon, as Tehran escalates to put pressure on Washington ahead of the US midterm elections. The silver lining is that both markets and central banks are reacting pretty much as they should. That bodes well for longer-term stability, at least.
Winter war tightens banks
The US and Iran exchanged strikes on each other’s ships this week, as Tehran attempts to expand its Strait of Hormuz chokehold to the wider Persian Gulf. Meanwhile, alternative shipping routes through the Red Sea are being hit by Houthi attacks. Brent crude oil is $104pb at the time of writing, while European natural gas prices are at their highest since late 2022.
Bloomberg reported today that six Gulf state representatives could meet with Iranian officials next week to discuss opening the Strait. The potential weakening of Gulf support for the US and Israel’s war dragged oil back from Thursday’s highs. Oman already held bilateral talks with Iran two weeks ago, with the failed talks partly motivating Tehran’s aggressive new stance.
After Eurozone inflation came in at 3.3% year-on-year in August – and energy inflation an eye-watering 14.3% – the ECB unsurprisingly raised rates, no longer willing to wait out the energy crisis. With no end to the war in sight, Europe is approaching winter with natural gas storage at seasonal lows.
At the Jackson Hole conference in August, central bankers lined up to say that energy price rises will force tighter monetary policy. Next week, the Federal Reserve and the Bank of England are expected to either hike or signal future hikes (US on 28th October, UK on 5th November). The ECB was merely the first.
No reprieve from fiscal risks
Higher rate expectations pushed up short-term bond yields, but long-term yields moved up by the same amount or more. In market jargon, there was very little ‘flattening of yield curves’ – the shape of bond yields across different maturities. This is slightly counterintuitive. Hawkish central banks should mean high rates now but lower future inflation, compressing long-term yields. Indeed, markets’ implied long-term inflation expectations have barely moved.
That is partly a liquidity effect: tighter monetary policy means less money for traders to buy long-term bonds, regardless of what the fundamentals might suggest. But it also reflects the fact that so-called ‘risk-free’ government bonds are getting riskier.
Higher energy prices worsen government finances, through higher interest costs and lower real growth. Leaders are confronted with difficult decisions. Prime Minister Andy Burnham said this week that national security “can’t come at the expense of social security” and Chancellor John Healey – who resigned the previous cabinet over underfunded defence – agreed with him. It was nominally a sign of making tough decisions, but some investors saw it as decisions avoided. Future threats could force defence spending anyway, and underinvestment now could increase the future cost.
Political rhetoric might explain some UK bond underperformance this week but, as usual, it was mostly down to global market moves. We argue UK debt is not in a ‘doom loop’ in a separate article.
At least British and European leaders talk about fiscal restraint – unlike the US. On Wednesday, Donald Trump promised to give every American adult $5,000 if his Republican party wins both houses of congress in November’s midterm elections. To put it politely, the slim chance of a Republican double victory (15% according to Kalshi) makes it easier to make such a pledge.
To many, it does suggest the administration is unconcerned about fiscal discipline, however. Treasury Secretary Scott Bessent, usually styled as the adult in the White House, did not help the bond market mood either. He talked tough about wanting a stronger yen, promising coordinated action with Japan, urging the Bank of Japan to raise rates and even daring currency traders to bet against him. But the bravado came across as anxiety that Japan might start selling its vast stock of US treasury bonds – pushing US yields even higher.
Reasons to hope – but brace for liquidity impact
The tough economic decisions are currently falling to central banks, not governments. Rate hikes will bite, but it helps markets in the long-term that someone is doing so, at least.
Energy resolution would alleviate the need for hikes. Lasting peace looks a way off, but we could see some calm following the current tensions – as in June. Iran projects strength, but its aggressive tactic is motivated by painful US attacks and sanctions. Even Iranian ally China has an incentive to pursue energy stability – if not full peace – due to its weak economy.
We should also remember that year-to-date equity returns have been strong. Even after this week’s yield reaction, global stocks are only marginally below July’s all-time high. Equity resilience is down to strong corporate earnings growth – growth which seems impervious to higher energy prices.
Things could get more difficult before they get easier. Stocks might not be able to shrug off higher policy rates, as they have higher yields. Rate hikes mean market traders are less able to borrow – reducing overall market liquidity and making risk assets feel riskier.
The fundamentals are still strong for markets, and politicians (especially in the US) have every incentive to find good news. A Trump-Xi Washington summit is expected to begin on 24th September and preliminary talks about trade and AI are rumoured to have started. We write about the summit in a separate article. Unfortunately, any positives must be balanced against potentially tighter liquidity, possibly creating greater volatility as we head into the Autumn.