Natural gas replaces oil as Europe's new inflation "powder keg": gas storage hits five-year seasonal low, TTF nears five-month high, central bank rate hike risks reignite

According to Zhitong Finance APP, as European natural gas prices approach their highest level in five months and storage levels fall to the lowest for the same period in years, bond investors and policymakers are shifting their primary concerns from oil to natural gas. Analysts warn that natural gas has a much stronger transmission to inflation in the eurozone and UK than oil, and it receives almost no cushioning from fiscal policy, which may force the European Central Bank and the Bank of England to reassess their rate hike paths. The latest forecasts show that the overall inflation rate in the eurozone will peak at about 4.2% in January 2027, significantly higher than the current level.

Since the escalation of the US-Iran conflict at the end of February 2026, the trends in European natural gas and oil prices have clearly diverged. As of press time, Dutch TTF front-month gas prices have risen from around €32/MWh at the end of February to €64, about double the level a year ago; European natural gas prices are near a five-month high, and winter contract prices are more than double those a year earlier. In contrast, Brent crude has risen from $71 per barrel before the conflict to about $86 now—still more than $10 higher per barrel, but has fallen sharply from the Q2 peak and is about 30% below the peak driven by the US-Iran war.

This divergence is reshaping risk pricing in the European bond market. German and UK 10-year sovereign bond yields have reached the highest levels in decades, and market participants point out that among the energy factors pushing yields higher, natural gas has replaced oil as the most critical variable.

Citi European Rates Strategist Jamie Searle said, "Natural gas prices have now become the key driver for yields. Since early July, duration has continued to follow natural gas prices, while attention to oil prices has relatively decreased." He referred to the increased correlation between the 10-year benchmark bond and gas prices.

Emma Moriarty, a portfolio manager at CG Asset Management, also emphasized, "Gas prices are more relevant to the UK and Europe, and there hasn't been any real pullback even with ceasefire deals—instead, prices keep rising." The firm has raised inflation-linked government bond positions in its flagship multi-asset fund to near-record 49%, citing increased risk of sustained price pressures.

"A potential energy crisis is brewing in the natural gas market, and its inflation transmission is far greater than oil," wrote RBC Capital Markets strategist Megum Muhic and others in a report on August 13.

Fiscal Buffer's "Oil Bias"

The latest data show that the eurozone’s inflation rate rose from 2.8% in June to 2.9% in July, with the energy sub-index accelerating year-on-year from 8.5% to 10.3%. One key driver of the rebound in energy inflation is the expiry of fiscal buffering measures previously introduced by various countries in response to rising oil prices.

According to tracking by Bruegel Institute, European countries promised a total of €11.8 billion in fiscal expenditure to combat the energy shock, the largest single item being fuel excise tax cuts and electricity VAT reductions, with over half of the measures not targeting specific groups. Spain committed €4.7 billion, including €2.6 billion in fossil fuel and electricity tax cuts from March 21 to June 30; Germany’s €1.6 billion in energy tax cuts covered May and June; Italy’s motor fuel excise tax cut lasted from March through May; Ireland’s measures extended through July. Most measures in Germany, Italy, and France expired at the end of Q2, while Spain's fuel discounts were gradually reduced over the summer.

The withdrawal of these measures is directly reflected in the July data. In Germany, motor fuel prices surged 23.0% year-on-year in July as the fuel discount ended on June 30; in contrast, household energy prices fell 1.4% year-on-year, still benefiting from remaining relief. Eurozone energy inflation rose from 8.5% in June to 10.3% in July, largely due to the retreat of fiscal buffers.

By contrast, natural gas has received virtually no fiscal protection on a similar scale. Europe’s exposure to natural gas is transmitted mainly through prices rather than quantities. More critically, the increase in natural gas prices is about three times that of oil, but lacks corresponding policy hedges. Turnleaf Analytics, a macroeconomic and inflation forecasting technology company, pointed out in its August 18 forecast that, as most oil-related relief measures have expired and the remaining ones will gradually withdraw, the impact of natural gas prices will become more evident in winter.

Hormuz Bottleneck and Storage Crisis

In addition, the vulnerability of the European gas market also stems from structural supply-side bottlenecks and insufficient inventory buffers. The Strait of Hormuz typically accounts for about 20% of global LNG supply, and unlike oil, there is no alternative shipping route for natural gas, nor is there any substantial strategic reserve to absorb supply gaps.

Since the end of March, Qatar Energy has suspended some exports due to force majeure, and this has been extended to October. Although Qatari gas accounts for less than 4% of total EU gas imports, making direct losses limited, the problem is that Asian buyers absorb over 80% of Qatari exports, and are now competing with Europe for spot LNG in the Atlantic basin.

In the weeks following the conflict, Asian JKM benchmark prices surged 51%, Dutch TTF was up 35%, while US Henry Hub prices fell 9%. Europe is not physically dependent on Qatar, but is a price taker in this market.

The weak level of inventories has aggravated the shock. On April 1, 2026, EU gas storage was only 28% full, the lowest in four years; by early July, it had recovered to around 49%. On August 13, storage levels reached 60%, about 61% by mid-August, still the lowest for the same period in five years. EU law requires storage levels to reach 90% by November 1, with 80% suggested in difficult circumstances and a minimum exemption permitted to 70%. Achieving the 90% target would require LNG imports about 13% higher than in 2025, but currently, Asia holds the marginal bidding power in the market.

RBC strategists point out that even if there is a breakthrough in the Middle East and oil prices fall further, as long as natural gas supply concerns persist, interest rate pressures will not ease. "This makes the risk distribution for rates asymmetric: there is limited upside in the market, while escalation means significant downside risk," they wrote in a report.

Turnleaf Analytics' projections show that the overall inflation rate in the eurozone will rise to about 3.4% in August, peak at around 4.2% in January 2027, then drop to about 3.2% in April and stabilize around 3.4% by July. This path is influenced both by natural gas and energy price levels and by base effects.

Energy inflation in the eurozone is negative every month from November 2025 to February 2026, with a year-on-year drop of 4.0% in January 2026. Thus, even if euro-denominated energy prices remain steady, the year-on-year increase will be pushed higher by base effects in January and fall back once the base turns positive in March. Turnleaf said its August 18 forecast is about 0.3 percentage points lower than that on August 3, mainly reflecting the decline in Brent prices, but natural gas prices have not dropped in tandem.

In terms of inflation components, energy accounted for 9.0% of the eurozone HICP basket in 2026, with energy inflation of 10.3% contributing about 0.9 percentage points to overall inflation. Services have a 46.8% weight, with a year-on-year increase of 3.3%, having remained between 3.0% and 3.5% over the past year; non-energy industrial goods have a 25.2% weight, up 0.9%; food, alcohol, and tobacco accounted for 18.9%, with inflation dropping from 3.2% in August 2025 to 1.2% in July 2026. These figures indicate the eurozone still faces significant relative price shocks, but core inflation has yet to fully absorb the rise in energy prices.

Turnleaf's contribution decomposition shows that the largest contributor to eurozone trade energy prices is the Dutch TTF gas rolling average, ahead of Brent front-month prices, and the market-implied eurozone core CPI also plays an important role in the model.

Central Banks and Markets Face Asymmetric Risks

This year to date, the European Central Bank has raised rates once, while the Bank of England has held steady. Money markets are currently pricing one more rate hike from each central bank by the end of 2026, and another round for each by September 2027. But several strategists believe that, given the rise in gas prices and lack of progress in the Hormuz Strait negotiations, these assumptions may need to be adjusted.

Steven Barrow, G10 strategy head at Standard Bank, stated: "This latest inflation threat stems from the difficulties of storing energy, as well as the impacts of summer heatwaves and droughts, making us more cautious. We are ready to raise our interest rate forecasts at any time." RBC strategists emphasized that even if a Middle East ceasefire presses down oil prices, if gas supply problems persist, pressure on rates will remain, with risk skewed to the upside.

Although the surge in bond yields is also driven by other factors, including unsustainable public finances, massive bond issuance by hyperscale cloud providers, and unpredictable US policy, market participants believe that among energy-related risks, natural gas now poses the biggest threat to the interest rate outlook in Europe and the UK.

The forex market is also beginning to reflect this risk. Strategist Adam Linton noted that the euro's rally against the dollar may soon encounter resistance from high natural gas prices. At present, the correlation between energy prices and the euro is not strong enough to justify dominance of the exchange rate, but as gas prices rise, this link is worth closely watching.

For Europe, the coming winter will be a crucial test. Storage buffers are weak, fiscal shielding is absent, Hormuz supply risks remain unresolved, and the buffering role of renewables may diminish during winter peak demand and low output periods. The scenario of eurozone inflation spiking to 4.2% next January is gradually becoming the baseline that bond markets and central banks cannot ignore.