Iran war drives UK curve risk premia, not rate hikes
Bank of England staff estimated a term structure model to separate near-term risk premia from central expectations for Bank Rate. The model found that the upward slope in short-term UK OIS rates after the Iran war primarily reflected risk premia, not higher expected policy rates.
War's shadow on the short end
The model estimates indicated that the upward slope observed at short maturities in the UK OIS curve following the Iran war in February 2026 largely reflected risk premia.
After stripping out these premia, the model-implied expected path for Bank Rate was broadly flat over the subsequent year.
Short-end risk premia, which were unusually high by historical standards (though not unprecedented, with higher levels seen during 2022-2023), reflect the compensation investors demand for uncertainty around the policy path.
This uncertainty, the authors argue, stemmed from the war and its macroeconomic effects.
Market intelligence and the Market Participants Survey (MaPS) corroborated central expectations that Bank Rate would remain on hold, creating a significant divergence from the naive reading of the forward curve.
Tailored model for policy insights
Standard affine term structure models (ATSMs) often prioritize overall fit across the yield curve, potentially misattributing short-end risk premia to expected Bank Rate.
To address this for the February 2026 episode, the Bank of England staff adapted the Joslin et al (2011) framework in three key ways.
First, the model was estimated using OIS rates instead of government bond yields, providing a cleaner input by avoiding liquidity premia and market distortions.
Second, a richer factor structure was incorporated to capture more flexible yield curve dynamics.
Third, survey information from MaPS and Consensus Economics on near-term Bank Rate expectations was directly integrated into the estimation process, materially improving the identification of the expectations component from risk-neutral pricing.
A crucial lens for policy
This study highlights the critical need to disentangle market expectations from risk pricing, especially during periods of high uncertainty.
Its adapted model provides a more accurate read of underlying policy expectations, preventing misinterpretation of financial conditions.
This methodological refinement offers central banks a sharper tool for forward guidance and communication, ensuring market signals are not distorted by transient risk aversion.