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A year ago, the focus at major central banks was how quickly interest rates could be cut. The United States (US) Federal Reserve (Fed) was guiding markets toward a more neutral rate environment, the European Central Bank (ECB) had already started easing, and the Bank of England (BoE) was waiting for clearer signs on inflation and wages before making its move to cut. Markets entered 2026 expecting a relatively stable backdrop. That all changed however after the events of 28 February, when the US launched a strike against Iran, causing inflation concerns to resurface sharply, forcing policymakers to reassess their outlook.
Losing the war on inflation
This week’s inflation data reinforced that shift. US Consumer Price Index (CPI) inflation rose to 3.8% year-on-year in April from 3.3% in March, its highest level since May 2023, driven largely by energy prices, which are now up almost 18% over the past year. US core inflation also moved higher to 2.8%.
In the United Kingdom (UK), producer inflation surprised to the upside, with input costs rising 7.7% year-on-year in April, while output prices increased 4%. Eurozone inflation was confirmed at 3%.
The common theme across all regions is that inflation is no longer moving comfortably toward target levels. The key question now is whether this is simply a temporary supply shock or the start of broader, more persistent inflation pressures. At the moment, it appears to be evolving from one into the other.
Inflation risk rises
Higher energy costs initially affect producers and supply chains, but these pressures are eventually filtering through to consumers. The UK’s producer price data already indicates that this process is underway. Input costs rise first, followed by output prices, and finally consumer inflation. By the time CPI starts accelerating meaningfully, the pressure has often been building for months.
This creates a difficult backdrop for newly confirmed Fed Chair Kevin Warsh. Although he was widely seen as supportive of lower rates before his nomination, the inflation backdrop now makes that position far more complicated. Fed officials have recently emphasised that further rate hikes are a possibility if inflation continues to accelerate.
Markets have adjusted quickly. Expectations for a US rate hike in 2026 have risen sharply over the past month, while bond markets have already repriced higher-for-longer interest rates. The US 10-year Treasury yield climbed to 4.67% this week, while the 30-year yield briefly moved above 5% for the first time since 2007. Higher long-term yields increase borrowing costs across the economy, from mortgages to corporate financing, while also putting pressure on equity valuations. Europe is seeing a similar shift, with markets now pricing in possible ECB hikes later this year after previously expecting only cuts. In the UK, rising gilt yields are again raising concerns around financial stability risks within pension and insurance markets.
MARKET MOVES
Bonds
The 10-year Treasury yield rose to 4.62% on Thursday following reports that Iran’s Supreme Leader, Mojtaba Khamenei, has insisted that near-weapons-grade uranium remain in the country, hardening the standoff with Washington. Oil prices are again under upward pressure, reviving inflation concerns. The Fed’s Federal Open Market Committee (FOMC) minutes also indicated that most policymakers still see further hikes, as appropriate, if inflation remains sticky. Markets continue to favour a hold through year-end, although the probability of a December hike has increased to about 40%.
German bund yields have edged up to 3.10% on Thursday after the eurozone’s Purchasing Managers Index (PMI) unexpectedly contracted in May, at its sharpest pace since late 2023. At the same time, war-driven energy costs pushed input price inflation to a three-year high. The ECB held rates last month, but signals from both public and private channels increasingly point to a June hike.
The UK’s gilt yields held near 4.97% despite a UK PMI contraction in May, the first in 12 months. Businesses reported weaker output, supply shortages, job cuts, and rising costs. The BoE therefore faces a difficult balancing act: inflation remains above target, even as the economy loses momentum.
Japan’s 10-year JGB yield eased to around 2.77% from recent 30-year highs after US President Donald Trump signalled that Iran negotiations were in their final stages, easing pressure on Japan’s import-heavy economy. At the same time, Japan’s first quarter gross domestic product beat forecasts and April exports rose 14.8%, supporting expectations of a near-term Bank of Japan rate hike.
Equities
US futures are slightly firmer this morning after two consecutive gains on Wall Street. The Dow rose 0.55%, the S&P 500 gained 0.17%, and the Nasdaq added 0.09%. Eight of the 11 S&P sectors closed higher, led by utilities, consumer discretionary, and materials. Despite mid-week volatility, the week remains positive overall, with the Dow up 1.53% and the S&P 500 ahead 0.5%. Sentiment has also been supported by US Secretary of State Marco Rubio’s comments that there are “some good signs” of progress toward an Iran deal, alongside reports that Tehran sees the latest US proposal as narrowing the gap, however, as mentioned above, risk remains.
The European STOXX 50 closed flat at 5,974, while the STOXX 600 rose 0.2% to 622 on Thursday. Iran’s stance on uranium tightened the supply outlook and pushed yields higher, weighing on banks, with UniCredit and Intesa Sanpaolo both down approximately 2%. Chip manufacturer Nvidia’s earnings report provided little support to the AI sector. Chemical stocks outperformed, with BASF and Air Liquide each gaining about 2%.
The UK’s FTSE 100 edged up to 10,443 despite weak factory order data, which showed the sharpest contraction since 2020. Multinational investment manager 3i Group and multinational energy companies SSE and Centrica led the gains, while digital vehicle marketplace Autotrader fell nearly 9% after disappointing full-year guidance, and global medical company Convatec dropped close to 5% on slower revenue growth.
Commodities
Brent is trading back above $104/barrel mark, but remains more than 4% lower for the week as hopes of a deal have eased the supply-risk premium. The diplomatic path, however, remains difficult. Iran’s Supreme Leader has reportedly ordered that enriched uranium reserves remain in the country, directly challenging Washington’s demand for Tehran’s nuclear programme to be dismantled. Iran is also working with Oman on a formal toll arrangement for vessels passing through the Strait of Hormuz, a proposal President Trump has rejected. Rubio was more measured, citing encouraging signs and confirming that Pakistani mediators will travel to Tehran to continue talks.
Gold is holding just above $4,520/ounce and is set to end the week broadly unchanged, reflecting the mixed signals facing markets. Some optimism came from Tehran’s acknowledgement that the latest US proposal has narrowed differences, but this has been offset by the uranium directive and the Hormuz toll proposal. Gold is still around 14% below where it traded at the start of the conflict, as the energy-driven inflation shock has reshaped safe-haven flows and kept rate-hike expectations alive.
Currencies
The US Dollar Index is trading near 99.2, its strongest level in six weeks, as mixed signals from Iran continue to keep inflation risks in focus and rate-cut expectations sidelined. While Tehran has partly acknowledged progress in talks, the uranium directive and Hormuz toll dispute have left the outlook unresolved. The FOMC minutes also showed that most Fed policymakers still view further hikes as possible if inflation remains elevated. Markets are pricing in a roughly 40% chance of a December hike, with rates otherwise expected to remain on hold through year-end.
The euro has slipped back to around $1.16/€, near its weakest level since early April. May PMI data showed the eurozone contracting at its fastest pace since late 2023, as war-driven energy costs pushed input-price inflation to a three-year high. S&P Global also warned that headline inflation could approach 4% in the coming months, making a June ECB hike increasingly likely.
Sterling is holding around $1.343/£ after May PMI ended a 12-month run of growth. Businesses reported weaker output, supply shortages and job cuts, highlighting pressure across the economy. UK Chancellor of the Exchequer Rachel Reeves announced some relief measures, including tariff suspensions on more than 100 food items and temporary VAT cuts on summer attractions, which may offer limited domestic support.
*Please note that all information is at the time of writing.
Key indicators:
GBP/USD: 1.3429
GBP/EUR: 1.1558
GBP/ZAR: 22.15
BRENT CRUDE: $105.56
GOLD: $4,527.52
Sources: Sources: CBS News, CNBC, Trading Economics, US Bureau of Labor Statistics and US Treasury / Treasury Borrowing Advisory Committee.
Written by Citadel Advisory Partner and Citadel Global Managing Director, Bianca Botes.
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