UK politics exacerbates effects of Iran war oil shortage

May 2026

The economist's corner

Geopolitical risk remains the key driver of movements in UK financial markets and, even before the local elections, UK gilts were showing more signs of volatility compared to other G7 sovereign debt markets. However, domestic political risk will likely exacerbate some of the challenges arising from the energy price shock.

Things are febrile. Since the last Rate Wrap, we have hit an unwelcome milestone of the 30-year gilt yield reaching highs last seen in 1998, while 10-year yields have breached 5% at intermittent points. As news bulletins have been dominated by turmoil in the UK government, a natural question to ask is ‘How much of this can be attributed to domestic political risk?’. The short answer is that, while political turbulence is certainly very unnerving for investors, geopolitical factors continue to be the main story in town.

It is notable that equity markets have been fairly resilient in the face of the Iran war, in large part due to bullish sentiment towards AI-linked stocks, and it is too soon to discern the impact on the UK property market (our recently published Property Investor Report Opens in a new window gives more colour on this). However, concerns related to the energy price shock have led to enormous pressure on government bond markets and, even prior to the local elections, we have seen UK gilts being especially volatile.

From the end of February to the beginning of May, UK base rate expectations for this calendar year shifted from two cuts to between two and three hikes. Moreover, UK 10-year gilt yields rose more than any other G7 country over this period (see Figure 1). Volatility in UK sovereign debt markets has been influenced by a variety of factors, including inflation risk and the UK’s over-reliance on overseas investors to service its debt obligations.

Figure 1: Change in G7 10-year Government Bond Yields

Fast forward to the local elections which took place on 7 May and the UK’s gilt market again witnessed greater volatility in comparison to G7 sovereign debt markets. And this time around, of course, the critical factor appeared to be UK political risk associated with the fallout from the government’s disastrous performance at the polls. After the results flowed in, outsized movements in UK gilts were observed almost immediately as speculation about the prime minister’s future gathered pace. Moreover, a similar situation occurred when it was announced that Andy Burnham, currently Mayor of Greater Manchester, was likely to stand in a by-election to enter parliament and challenge Sir Keir Starmer for the leadership.

Figure 2: Change in G7 10-year Government Bond Yields

Note: This period captures the immediate aftermath of the UK’s local elections

Many will welcome that for a few short weeks UK political risk is now likely to take somewhat of a back-seat as we await the outcome of the Makerfield by-election. However, whatever the result, instability in the government will likely follow. And if Andy Burnham were to become prime minister, an outcome which is highly likely if he wins the by-election, his previous comments about not wanting to be in hock to the bond market will naturally make investors nervous. They may end up being reflected in UK borrowing costs, at least initially, even though he has since tried to row back on this view. Some commentators estimate that this outcome could end up adding another 30 – 40bp to 10-year gilt yields.

In summary, the energy price shock arising from geopolitical instability is the key driver of negative movements in UK financial markets and the macro outlook, but UK political domestic risk is exacerbating these challenges. In our latest Global Macro Forecast Opens in a new window, we have set out three scenarios for how this backdrop could play out for the UK economy: a benign scenario, a base case (central view) and an adverse scenario. Oil price futures would suggest the current situation (as of 20.05) is slightly worse than our base case scenario, which points to a UK inflation peak of over 4% and the next move in interest rates being upwards.

We are currently on course to avoid recession this year, although the collapse in May's business PMI reading shows that private sector activity is taking a major hit. And should an adverse scenario end up playing out, our judgement on this would change due to the government lacking any material fiscal tools to respond. The UK, after all, is currently paying the highest level of interest on its newly issued debt within the G7, a situation that has been present since the beginning of 2025.

Daniel Mahoney, Senior Economist, UK

A view from the dealing desk

UK swap rates move higher

In Daniel’s section above, he highlights the two main factors that are plaguing the UK bond market currently: the inflationary pressures arising from the US-Iran war, coupled with growing political risk following Labour’s significant losses in May’s local elections, where Reform won heavily.

Naturally, the same developments have had an impact on the UK swap market, where rates across all tenors have increased considerably over the month. Focusing on short-term movements, market pricing continues to point to two hikes totalling 0.5% in 2026, with a further hike fully priced by April 2027. This month has seen a lot of fluctuation in the pricing of a third hike, mainly in line with geopolitical headlines and the movement in oil prices which the swap market has been highly sensitive to.

Swap rates further out on the interest rate curve have moved back to their March highs, as the stalemate between the US and Iran drags on with no sign of ending. The move higher over the month ranges between 0.35% and 0.40% across 2-10 year swaps – five year swaps traded around 4.5% at its high before dovish UK data took some heat out of swap pricing towards the end of month.

The curve is flat, and not inverting

What is notable is that the curve remains flat, and not inverted (where longer-term rates are lower than shorter-term rates and which are a well-known recession indicator) as of now, highlighting that markets currently see the need for persistently higher rates in the long run. There are a few explanations for this.

Firstly, we are at an early stage in the current oil shock, which makes it difficult to understand the longer-term consequences for economic growth with the outlook so cloudy. The more immediate concern remains inflation, and more importantly inflation expectations given the fear amongst many – including members of the Monetary Policy Committee – that expectations could become even more unanchored, driving broader price pressures. MPC member Megan Greene noted while speaking on a panel in Italy this month that central banks need to lean against negative supply shocks “pretty proactively”, adding that “we do have to worry about wage and price setting”.

Secondly, economic data is holding up better than expected, evidenced by strong growth numbers in Q1 (0.6% QoQ) as well as business sentiment holding up amidst a war, as shown in the PMIs which have outperformed, although May’s flash numbers did deteriorate. The labour market data is a tricky read. April’s initial payroll numbers showing a 100k drop is alarming at face value, but will most likely be revised up in May’s figures. This highlights the statistical nuances that reduce some of the value in this data, but broadly speaking the numbers have surprised to the upside, providing a better platform for UK growth heading into the latest shock.

Finally, and the most topical explanation, are developments in Westminster. A change of leadership in the Labour party and shift to the left is unsurprisingly causing some concern in markets on the prospect of a more fiscally loose government putting pressure on public finances – as noted in Daniel’s section above - despite frontrunner Andy Burham stating he would commit to the current fiscal rules. That concern has been well documented in gilt markets, but that has not been reflected solely through an increase in risk premiums (or the compensation demanded for holding that bond). In fact, the 10-yr swap spread, which reflects the difference between the 10-yr swap rate and 10-yr gilt yield, and is used as a barometer of gilt risk premium, has not widened following the local election result. Therefore a change in leadership is also being reflected in swaps, with the possibly of structurally higher spending constraining the Bank of England’s ability to bring interest rates down, leading to more restrictive interest rates in the long term.

Figure 6: UK 2, 5 & 10 Year Swaps since mid-2022

Inversion could still materialise if the medium to long term economic consequences of the latest shock exacerbate negatively, (oil shocks typically do lead to recessions) pushing longer term rates down. The previous experience of inversion started in mid-2022 following Russia’s invasion of Ukraine, and lasted through early 2025 – as shown in the chart above. However, the inflation surge was due to both a supply (energy) shock and a demand shock, caused by unleashed pent-up demand following Covid lockdowns, which the Bank of England underestimated. The inflation shock that resulted required a huge increase in interest rates beyond neutral levels, which would subsequently need to be brought back down as inflation cools and the economy slows – as they indeed were.

The environment this time is different, the Bank of England is aware of previous mistakes, and is conscious that inflation has been above target for five years and inflation expectations are not as well anchored as they used to be. This in theory may reduce the risks of policy mistakes that require significant quickfire rate increases, but equally, inflation expectations may limit the BoE’s ability to bring down interest rates even if the economy slows.

The UK is not alone

The gilt market tends to grab the headlines and be punished more than others in global selloffs, which in part stems from a lack of market trust following the 2022 mini-budget, but also on the view that the UK is experiencing more of an inflation problem. This however does not hide that other economies and bond markets are also suffering from the fallout in the Middle East. Take Japan as an example, where JGB yields have pushed higher, with the 30-yr yield reaching 4% for the first since its inception in 1999. That was due to the Japanese government announcing a supplementary budget to support households through energy subsidies, backtracking on previous statements that no additional funding would be sought. Japan is subject to concerns around fiscal sustainability as well as inflation expectations, whilst markets expect a couple of interest rate increases from the Bank of Japan in 2026 – sound familiar?

The US rates market has been calmer relative to others since the war began, but the US-Iran stalemate is also starting to turn the dial. Markets are now expecting the next move from the Federal Reserve to be a hike by January next year, albeit that could still be brought forward into 2026. This complicates the start of a new era at the Fed, as Kevin Warsh, who has a preference for lower interest rates, takes office as the new chairman.

US Treasuries are also now on the move, with the 10-yr yield surging above the key 4.5% level without much of a fight. The jump accelerated after the US-China summit which yielded no significant commitments, or plans to tackle the Strait of Hormuz closure. The 30-yr touched close to 5.18%, the highest level since 2007. The lack of buyers at these levels is being attributed to the unknown timeline for a resolution in the Middle East, but this coupled with the possibility of active or passive selling of Treasuries from the Fed as it reduces its balance sheet (another preference of Mr Warsh) as well as growing fiscal risk resulting from huge spending gaps. These will in turn be challenged further by the striking down of tariffs by the US Supreme Court and higher interest costs all of which may exacerbate the trend as investors demand more compensation.

Figure 7: UK, US & Japanese 30-yr yields since 2000

Ultimately geopolitics and energy prices remain the driving force of the global rates market, and movements in oil prices will continue to be the epicentre. The summer may bring new challenges as stockpiles are used up by refineries, with energy experts warning of a tipping point from June, leading to further shortages or price hikes. President Trump is still searching for an off-ramp ahead of midterms later this year, but time is running out. Let’s see if his recent comments that talks with Iran are in its final stages materialise into a concrete agreement.

Cameron Willard, Markets

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