The bond market is concerned about a surge in inflation, pricing in an aggressive interest rate hike cycle; meanwhile, the stock market maintains high valuations, betting that an economic slowdown will force interest rate cuts. Analysts point out that equity investors are optimists, focusing on future profits, while bond investors are entirely concentrated on protecting themselves from the erosion of inflation.
Amid the Iran war shock, a rare internal tug-of-war is unfolding in Euro-American financial markets. The bond market has priced inflation risks at multi-year highs, suggesting an imminent rate hike cycle, while equity markets are signaling that economic slowdown will suppress interest rates and even trigger rate cuts.
In Europe, the interest rate swaps market has already priced in three rate hikes by the European Central Bank this year, with Germany’s 10-year benchmark government bond yield hitting a 15-year high on March 27. Major institutional investors like Blackrock are still betting on further declines in bonds.
However, the pricing logic of European stock markets is markedly different: the price-to-earnings ratio of Stoxx Europe 600 Index components remains around 15 times expected earnings, far above the average of the past two decades. Analysts predict corporate earnings will grow by 11% by 2027.
In the U.S. stock market, the cyclically adjusted price-to-earnings ratio of the S&P 500 Index has recently remained above 38 times, placing it within a historical high range over the last 150 years. This divergence between stocks and bonds has spread to the world’s two core markets, leaving investors facing directional decisions.
Bond Market Expects Aggressive Rate Hike Cycle to Begin
The sharp reaction in the bond market stems from a direct projection of historical scenarios. According to Bloomberg, Amélie Derambure, Senior Multi-Asset Portfolio Manager at AXA Investment Managers in Paris, stated that the fixed income market is pricing the inflationary impact of this conflict as akin to the consequences triggered four years ago when Russia invaded Ukraine.
“I think the price reaction in the fixed income market has been particularly intense,” she said. “The equity market remains uncertain about the economic consequences of this conflict, but the bond market is already pricing based on the scenario of 2022.”
At that time, surging energy prices pushed eurozone inflation to record peaks, forcing the European Central Bank to initiate its most aggressive rate hike cycle in history.
This time, the situation in Iran has once again raised concerns about energy supply, compounded by Europe’s already elevated inflation base, prompting bond investors to react defensively first. Institutions like Blackrock are betting on further increases in yields, resonating with the three-rate-hike expectation in the interest rate swaps market.
Equity markets, however, believe deteriorating growth will constrain room for rate hikes.
The logic of the stock market forms a mirror image with the bond market. Investors generally believe that if geopolitical conflicts persist, the substantial drag on economic activity will render central banks unable to tighten policies significantly, making it ultimately difficult for interest rate hike expectations to materialize.
Karen Georges, an equity fund manager at Ecofi based in Paris, referred to this divergence as ‘market schizophrenia,’ stating:
“We firmly do not anticipate two interest rate hikes, let alone three — considering how a prolonged crisis could weigh on economic activity. If growth suffers a significant blow, one could even envision a rate cut before the end of the year.”
Analysts’ forecasts of an 11% increase in European corporate earnings for 2027 are similarly premised on assumptions of a benign economic environment and accommodative financing conditions, fundamentally contradicting the aggressive interest rate hike path priced into the bond market. Should economic slowdowns, earnings disappointments, and expectations of central bank easing fail to materialize, currently elevated stock valuations will face significant downward pressure.
U.S. stock investors continue the empiricism of ‘geopolitical shocks will eventually pass.’
American equity investors have adhered to a repeatedly validated empirical strategy: viewing geopolitical shocks as temporary disruptions and holding positions through periods of turbulence.
According to Bloomberg, George Nadda, a portfolio manager at Altana Wealth based in London, stated: “Recent history has taught investors to regard geopolitical disturbances as short-lived phenomena since the actual impact of such events on the economy tends to be relatively limited.”
Historical data supports this assessment — during both the Gulf War and the Iraq War, oil prices surged significantly, yet stock markets recorded gains within six months after the onset of conflict; similar patterns were observed during the early stages of the Ukraine war in 2022 and the tariff shock around Liberation Day in April 2025.
Under this logic, U.S. sell-side analysts have generally been reluctant to lower earnings forecasts, with earnings per share estimates actually trending upward ahead of the April earnings season. Investors have also maintained optimistic expectations of robust U.S. economic growth that predated the outbreak of conflict.
Two assets, two distinct characteristics
The divergence between stocks and bonds reflects a fundamental difference in the mindset of investors in these two asset classes.
Kevin Thozet, a member of the Carmignac Investment Committee based in Paris, stated that the gap between the stock and bond markets can be partially explained by their respective basic stances.
“By definition, equity investors are optimists, focusing on future profits; whereas bond investors are entirely concentrated on protecting themselves from inflationary erosion.”
The arbiter of this divergence will ultimately be the direction of economic data and central bank policy.
If inflationary pressures continue to rise as feared by the bond market, stock valuations will face a dual squeeze from both interest rates and earnings. If growth becomes the primary issue as expected by the stock market, the aggressive pricing of bonds will gradually adjust. At present, both markets are waiting for the other to be proven wrong.
Editor/Liam
