Pound-Euro Looks to Shake Debt Market Jitters

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Pound sterling looks to recover last Friday's losses that were a response to sharp movements in domestic bond markets.

Pound sterling fell sharply against the euro on Friday on market fears the Iran war will trigger fiscal chaos in the UK; GBP/EUR fell half a per cent to 1.1530 by Friday's close, but Monday sees the start of a recovery with a climb back to 1.1546.

Bond markets are proving to be both a source of concern and support for the currency, depending on the mood of invetsors; last Friday was certainly an example of bonds being a concern as both UK gilts and the pound fell in tandem, which happens when investors are worried about the sustainability of the UK's public finances.

The concern here is that rising oil and gas prices caused by the war in the Middle East threaten to boost British inflation, while a heavily indebted government considers various energy bailout plans to please its voters.

The problem is, those who lend to the UK government know the public finances are ill-prepared for another crisis.

It's a potent cocktail for the currency - rising government borrowing costs, higher inflation, lower growth, rising unemployment and a Bank of England that might have to raise interest rates.

"We revise down our forecasts for real GDP in 2026 and 2027, but revise up inflation and unemployment in light of an intensifying energy shock," says a note from Barclays.

Above: GBP/EUR (top) and UK ten-year government bond yields. Friday saw a dinstinct parting of ways.

Barclays economists revise up their inflation forecast for 2026 to 2.9% (+0.7pp) and for 2027 to 2.4% (+0.4pp). They expect real GDP to grow 0.7% in 2026 and 1.2% in 2027 (previously 1.1% and 1.7% respectively).

"We expect Bank Rate to stay at 3.75% for the rest of this year," say economists at the bank.

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Although markets are showing some signs of concern, there's no panic, and this could allow the pound to recover this week.

For this to happen, rising bond yields must once again become a source of support for the pound.

Bonds fell and their yeilds rose last week in the wake of the Bank of England's policy decision, where rates were left on hold but where policy makers expressed concerns that inflation would limit the ability to lower rates much further.

(Bond markets respond to a combination of central bank policy and risk premium: as we have shown, both drivera have encouraged lower bond prices and higher bond yields this week).

"A factor that is affecting gilts more than some other markets is a recalibration of policy rate expectations. A week ago there was less than one 25bp hike by the BoE priced in but following the hawkish MPC minutes this week starts with over three 25bp hikes priced by markets for the rest of 2026," says a daily market briefing from Lloyds Bank.

For the pound-euro exchange rate, the question is whether or not rising bond yields prove supportive, or detrimental, this week.

If market volatility eases, then they become supportive, but if bond buyers grow on strike, we could be looking at the beginnings of another crisis.

GBP/EUR had steadily risen during the first two weeks of the Iran crisis when rising bond yields were proving supportive, with 1.16 being tested on numerous occasions over recent days.

However, that 1.16 level was not broken and the pair was resoundingly rejected on Friday, falling half a per cent back to 1.1530 by day's close. 

Above: Detailed map of the Strait of Hormuz.

The pound was able to rise when markets were optimistic that the crisis would be a short-lived affair, as were previous flare-ups involving Iran.

It's become clear that there's no quick end in sight and the damage to energy infrastructure is bad enough to ensure the global supply of gas and oil from the Middle East will be curtailed for some time.

On Monday, we hear Iran has threatened to destroy energy sites across the Middle East after Donald Trump gave the regime 48 hours to reopen the Strait of Hormuz.

Mohammad Bagher Ghalibaf, the Iranian parliament’s speaker, said overnight that oil prices would "rise for a long time".

U.S. President Trump on Saturday gave Iran an ultimatum, warning it would blow up Iran's electricity infrastructure within 48 hours unless it opened the Gulf of Hormuz to shipping.

The countdown to further chaos begins, not just in the Middle East, but in sterling markets too.