Government borrowing costs fell sharply on Tuesday, after a dovish speech from Bank of England governor and revived hopes of a Middle East peace deal led traders to pare back bets on central bank interest rate hikes.

Gilts rebounded across the curve, outperforming their European peers. The UK’s two-year and 10-year government bonds fell as much as six basis points each at market open, rebounding from a broad sell-off on Monday sparked by an apparent breakdown in communication between the US and Iran.

Officials in Tehran said they had withdrawn from peace talks with their American counterparts and threatened to launch a retaliatory strike on Israel, after Netanyahu’s government ordered an air strike on neighbouring Israel.

The flare-up in tensions sent the price of oil up to above $95 a barrel after falling more than 11 per cent over the course of last week. Bonds equities also sold off, as investors braced for a more protracted, pan-regional conflict.

But in an expletive-laded phone call on Tuesday night, Donald Trump demanded Netanyahu to abort his planned strikes on Beirut, calling the Israeli Prime Minister “f****ng crazy”. Israel called off the assault on a southern suburb of the Lebanese capital – a stronghold of Hezbollah, the Iran-affiliated militant group – at the last minute, prompting a partial rebound in equities and bonds.

The direction UK government borrowing costs have been closely tied to the direction of the war in Iran, since the onset of the conflict in late February. Economists have warned that Britain is particularly exposed to geopolitical and macroeconomic shocks borne from situations like the one playing out in the Middle East.

Relative to its peers the UK is heavily reliant on international oil and gas markets and has a greater proportion of regulated industries, meaning a short-term price shock take longer to fall out of inflation baskets.

The situation left the country facing the gravest change to its economic and fiscal outlook of almost any major developed economy, with its short-term bond yields rising over a full percentage point at the outbreak of the war, as traders braced for a fresh bout of inflation. Since then, its bonds have whipsawed with every development in the Middle East.

Bailey remarks calm borrowing costs

Tuesday’s rally was further bolstered by a speech given by Andrew Bailey on Friday, in which the central bank chief raised the prospect of not raising its central interest rate unless he saw evidence of so-called ‘second-round effects’ in the UK economy.

Bailey told a conference in Iceland: “Monetary policy generally looks through the direct effects of energy prices on inflation.

“It takes time for changes in interest rates to affect the economy and inflation, so higher interest rates might only push inflation below [the Bank’s two per cent] target once the energy price shock has passed, resulting in undesirable volatility in both inflation and activity.”

The remarks constituted some of the Bank of England governor’s most dovish since outbreak of conflict in the Middle East, and could be justified because the rate-setters’ hawkish messaging had tightened monetary policy.

Before the war, financial markets and mortgage providers had set borrowing costs on the assumption that the central bank would vote through as many as three 0.25 basis points cuts over the course of the year.

But Bailey said that by taking those cuts “off the table”, central bank officials have forced those private sector lenders to withdraw loans and products offered in the first two months of the year to price them differently.