During the US-Israel military conflict with Iran, the European bond market experienced severe volatility, with government bond yields soaring and directly pushing up borrowing costs for various countries. This shift is subtly exacerbating the already fragile public finances of the continent, especially against the backdrop of a significant slowdown in economic growth and the lingering effects of post-pandemic fiscal support measures. Even with signs of a ceasefire, market concerns about persistently high energy prices have prevented bond yields from falling, thus translating into a heavy interest burden for governments.

Despite a sharp stock market rebound fueled by expectations of a swift end to the war, analysts generally point out that the damage to infrastructure in the Gulf region leading to tight energy supplies and persistently high oil and gas prices will continue to weigh on bond market performance. Max Kitson, European interest rate strategist at Barclays, bluntly stated that rising yields are extremely detrimental to European public finances, inevitably translating into higher interest payment pressures. The following analysis details how this phenomenon is gradually eroding the fiscal space of European governments from multiple perspectives.

The real pressure of yields remaining at high levels

Even with the ceasefire agreement reached between the US and Iran, bond yields in major European economies remain well above pre-conflict levels. The main driver of this phenomenon is the widespread expectation among traders that rising energy prices will force the European Central Bank and the Bank of England to raise interest rates this year to combat potential inflationary pressures.

This week, the UK successfully auctioned a record-breaking 10-year government bond, with yields reaching 4.916%, the highest since the 2008 global financial crisis. Calculations show that France's 10-year bond auction earlier this month also saw yields rise to 3.73%, the highest level since the 2011 Eurozone debt crisis. Yields in core countries like Germany also saw significant increases, casting a shadow of high-level volatility over the entire European bond market. This rise in yields not only reflects a reassessment of market inflation expectations but also directly amplifies the cost of future government debt issuance.

High interest costs devour fiscal resources

The combined effects of massive fiscal spending during the pandemic and subsequent changes in the interest rate environment have placed the debt servicing costs of Europe's four largest economies at a high level or continuing to rise. This burden is becoming an increasingly prominent "hidden killer" in national budgets.

The UK's Office for Budget Responsibility (OBR) forecasts that net debt interest payments could reach approximately £109 billion (about $148 billion) in the 2026/27 fiscal year, far exceeding its defense budget of approximately £66 billion. This is primarily due to the high proportion of inflation-linked debt and generally high interest rates in the UK. France's debt servicing costs this year are estimated at around €59 billion (about $70 billion), while Germany's are around €30 billion.

International rating agency S&P Global Ratings points out that even before the outbreak of conflict, Italy's interest costs were projected to reach 9% of fiscal revenue by 2028. In France, due to a lack of consensus on fiscal policy, interest costs could climb to over 5% of fiscal revenue. These figures clearly demonstrate that interest payments are crowding out fiscal resources originally allocated to public services, infrastructure, or social welfare, making it increasingly difficult for governments to cope with downward economic pressures.

Huge refinancing needs amplify market risks

European debt management agencies must continue to finance their debt through the bond market to replace maturing debt. As yields remain high, the impact of the refinancing process will gradually become apparent, and although this process is relatively slow, its cumulative effect should not be underestimated.

Data from S&P Global Ratings shows that Italy will need to refinance 17% of its GDP in debt by 2026, compared to 12% for France, and 7% for both the UK and Germany. Andrew Kenningham, chief European economist at Capital Economics, said the situation is indeed worrying, and its severity largely depends on the future trajectory of energy prices and the extent of fiscal support measures governments take to protect their economies from high energy price shocks.

It is worth noting that countries like Italy, Spain, and Greece, which have previously experienced debt crises, have significantly reduced their primary deficits in recent years, thus lowering their sovereign risk. During this conflict, bond yields in these three countries were even lower than their peak levels in 2022 or 2023, demonstrating the market's relative acceptance of these countries' fiscal resilience. However, for Europe as a whole, the continued refinancing pressures still pose a long-term fiscal risk.

Inflation-linked bonds amplify interest rate sensitivity

Among major European economies, the UK has the largest exposure to inflation-linked bonds, which account for approximately 24% of its total bond holdings. Interest payments on these bonds tend to rise with inflation, making them particularly costly in environments of increasing inflationary pressures.

These types of bonds in the UK have proven costly during the post-pandemic inflation surge. According to the Office for Budget Responsibility, net debt interest as a percentage of GDP jumped sharply from 1.7% in fiscal year 2019-20 to 4.4% in fiscal year 2022-23. While analysts generally do not expect inflation to return to double digits, the office estimates that for every 1 percentage point increase in the inflation rate, debt interest costs will rise by approximately £7 billion this year, severely eroding Chancellor Reeves' remaining £24 billion "buffer" under fiscal rules.

The double-edged sword effect of shortening bond maturities

In recent years, developed economies have generally tended to shorten the average maturity of government borrowing in order to take advantage of the relatively low interest rates on short-term bonds. While this strategy does help control interest costs in a low-interest-rate environment, it also introduces new risks.

The International Monetary Fund (IMF), in its latest Fiscal Monitor report, explicitly warned that when debt is concentrated in shorter maturities, governments must refinance more frequently, significantly increasing their vulnerability to sudden changes in market conditions or investor sentiment. While this "shortening" strategy may temporarily alleviate pressure, it significantly increases the fiscal system's vulnerability to external shocks, especially in the current environment of high energy price uncertainty.

Conclusion: Profound Warnings from the Energy Crisis and Debt Cycle

The energy price shock triggered by the conflict in Iran is profoundly impacting the public finances of European countries through rising bond yields. High borrowing costs, refinancing pressures, and inflation sensitivity are intertwined, creating a potentially vicious cycle. If the energy supply shortage cannot be alleviated quickly, European governments will face an even more severe fiscal test: on the one hand, they will need to cope with slowing economic growth, and on the other hand, they will have to bear the burden of ever-increasing debt interest.

This situation serves as a reminder that the impact of geopolitical conflicts often extends beyond the battlefield, reaching deep into the global financial system. European countries face a difficult balance between fiscal sustainability and economic support measures, and market expectations regarding energy prices and central bank policies will continue to dominate the future direction of the bond market. Only when energy supplies stabilize and inflationary pressures truly ease can the pressure on European public finances be gradually reduced.

Furthermore, the conflict in Iran, driven by a sharp rise in energy prices, is expected to have a significant negative impact on the euro. As Europe's main energy importer, the eurozone faces a severe deterioration in terms of trade: soaring oil and gas prices have pushed up overall inflation expectations, leading to a shift in the European Central Bank's (ECB) policy path. The market had initially anticipated that the ECB might maintain interest rates unchanged or maintain a moderately loose stance in 2026, but after the conflict triggered stagflation concerns, investors quickly repriced, anticipating two or more rate hikes throughout the year. This change has narrowed the interest rate differential between the euro and the dollar, while simultaneously pushing up eurozone bond yields, further diminishing the euro's attractiveness.

Furthermore, the conflict has exacerbated the risk of a slowdown in Eurozone economic growth. Rising energy costs not only erode household consumption and business investment but also amplify public finance pressures through higher borrowing costs, leading to continued pressure on the euro in the foreign exchange market. Even with a ceasefire between the US and Iran, the slow recovery of energy supplies continues to put downward pressure on the euro, with the euro-dollar exchange rate falling to a multi-month low during the conflict, and the trade-weighted exchange rate also declining. This impact reflects the structural weakness of the euro as an energy-sensitive currency, making it more vulnerable to external shocks amid geopolitical uncertainty.

Overall, the Iranian conflict has strengthened the safe-haven and dominant position of the US dollar in the short term, while the euro has been put on the defensive due to the stagflationary shock, resulting in significantly increased exchange rate volatility. If the aftermath of the conflict persists, the euro's recovery will depend on the speed of the decline in energy prices and the European Central Bank's ability to balance policy.

At 14:25 Beijing time, the euro was trading at 1.1798/99 against the US dollar.