Expectations for interest rates in the UK have changed dramatically following the rise in global oil prices triggered by the worsening conflict in the Middle East, with investors now increasingly betting that borrowing costs could rise rather than fall in 2026.
The financial markets are calculating that there is a probability of around 70 percent that the Bank of England will raise interest rates by a quarter of a percentage point before the end of the year. This is a significant reversal from expectations two weeks ago, when traders were still expecting multiple rate cuts.
Just two weeks earlier, markets had predicted the bank would begin cutting its key interest rate from its current 3.75 percent, with the first cut expected at the Monetary Policy Committee meeting scheduled for March 19.
Instead, the escalating war between Iran, Israel and the United States has dramatically changed the economic outlook, sending energy prices sharply higher and threatening a new rise in global inflation.
The shift in interest rate expectations is primarily due to a rapid increase in oil prices as a result of disruptions to shipping routes through the Strait of Hormuz.
International oil benchmark Brent crude rose nearly 30 percent in a matter of days and briefly traded just below $120 a barrel, its highest level since the 2022 energy crisis.
At the same time, U.S. benchmark West Texas Intermediate crude posted its biggest weekly rise on record as traders feared continued disruption to global energy supplies.
The Strait of Hormuz. The route, which carries around a fifth of global oil exports, was effectively closed to normal commercial shipping after Iran threatened to attack ships using the route.
Energy traders warn that continued disruption could lead to a prolonged shortage of oil and gas in global markets.
While rising oil prices pose a global inflation risk, the UK economy is considered particularly vulnerable because it relies heavily on imported natural gas to heat homes and generate electricity.
Wholesale gas prices in Britain have already skyrocketed in response to the conflict, raising fears that household energy bills could rise again later this year.
Industry analysts have warned that the UK’s energy price cap could rise by up to £500 in the summer if current wholesale gas prices remain in place.
Higher energy costs would likely impact transportation, food production and manufacturing supply chains, driving overall inflation significantly higher.
Economists at Deutsche Bank forecast that U.K. inflation could approach 4 percent by the end of 2026, double the Bank of England’s official 2 percent target, if the conflict continues to disrupt energy markets.
The sudden change in expectations has caused severe turbulence in the UK government bond markets.
The 10-year Treasury yield, a key measure of the cost of government borrowing, rose around 0.4 percentage points to 4.74 percent in a week, the sharpest rise among major developed economies.
Bond yields rise as investors sell Treasury bonds, indicating expectations of higher inflation or tighter monetary policy.
Analysts said the move represented the sharpest sell-off in British bonds since the financial turmoil sparked by former Prime Minister Liz Truss’s 2022 “mini budget.”
Short-term borrowing costs have risen even faster. The yield on two-year Treasury bonds, which are particularly sensitive to interest rate expectations, rose as much as 0.25 percentage points in a single trading session.
The rapid repricing of financial markets reflects the view that central banks may now need to maintain tighter monetary policy for longer to contain inflationary pressures.
Dario Perkins, head of global macro at economic consultancy TS Lombard, said the oil shock had fundamentally changed the outlook for interest rates.
“Inflation is already overshooting targets and from the perspective of policymakers, this is making expectations more fragile,” he said. “All interest rate cuts have been postponed for now.”
The shift is not limited to the UK. Investors are also starting to price in the possibility that the European Central Bank could raise interest rates later this year, reflecting the euro zone’s heavy reliance on imported energy.
Major central banks around the world are reassessing the economic impact of the Middle East conflict.
Next week both the ECB and the Federal Reserve will announce their latest interest rate decisions.
Speeches from ECB President Christine Lagarde and Federal Reserve Chair Jerome Powell are expected to focus heavily on the potential impact of the oil shock on inflation, economic growth and interest rate policy.
The United States is slightly more insulated from global energy price shocks because of its large domestic shale oil industry, although gasoline prices have already risen to their highest level since mid-2024.
The shift in expectations has already begun to impact the UK property market, where lenders are adjusting mortgage prices in anticipation of higher borrowing costs.
Banks and building societies base their mortgage rates on financial market expectations of future interest rate movements, particularly via swap markets.
Several major lenders have already started increasing interest rates on new home loans.
Nationwide Building Society last week increased some mortgage products by 0.25 percentage points, while HSBC and Coventry Building Society confirmed similar increases would follow.
Higher mortgage rates could slow activity in the housing market as it has just begun to recover from turmoil caused by rising borrowing costs in recent years.
The potential impact of continued energy price increases goes well beyond monetary policy.
Economists warn that higher fuel costs could also push up food prices, especially if fertilizer supplies are disrupted by the closure of shipping routes in the Persian Gulf.
If oil and gas prices remain elevated for an extended period, the resulting inflationary pressures could force central banks to maintain tighter financing conditions even as economic growth slows.
The challenge is becoming increasingly clear for Bank of England policymakers: balancing the need to control inflation while avoiding further damage to an already fragile economy.
