Bond markets dominated by inflation fear, prompting rate-cut bets to fall

By Alun John and Yoruk Bahceli

LONDON, March 3 (Reuters) - A sharp two-day selloff in global government bonds underscores how the U.S.-Israeli air war against Iran is straining markets already on edge over inflation.

Bond prices tumbled on fears that a prolonged war against Iran would boost energy prices and sideline hopes for central-bank rate cuts. Yields pared their gains throughout the U.S. trading day, reflecting optimism among traders stateside that the conflict won't spiral into a lengthy crisis and on a stronger U.S. position in energy than European peers.

The action is the latest sign that government bonds’ longstanding status as a safe haven that prospers when markets turn rough is under pressure, adding complexity to already fraught trading decisions.

INFLATION CONCERNS

The spike in energy prices comes as many central banks including the Fed are struggling with above-target inflation.

"This is coming at a phase of the Fed's policy cycle where they are not in a position to be looking through transitory price increases," said Will Compernolle, macro strategist at FHN Financial.

A divided Fed is expected to keep rates steady for several months on concerns about still elevated price pressures.

Market volatility, with U.S. Treasury yields initially rallying on news of the conflict, also showed uncertainty over how it will ultimately impact the economy.

"The market is really struggling to find its footing. So, I think that explains the big intraday ranges," said Compernolle.

ECB Chief Economist Philip Lane told the Financial Times in an interview that a prolonged Middle East war could cause a substantial spike in euro zone inflation and reduce economic growth.

Two-year yields rose but were off their earlier highs.

Britain's GB2YT=RR were last at 3.732% after earlier reaching 3.84% — up from 3.516% on Friday, its biggest two-day yield increase since October 2024.

German DE2YT=RR two-year yields climbed to 2.177%, and got to 2.236%, the highest in a year and the biggest two day rise in a year. U.S. two-year yields US2YT=RR were at 3.498%, up from a low of 3.365% on Monday, and got as high as 3.599%. That is the biggest two-day rise since June.

"Nobody knows how long this will take," said JP Powers, CIO at RWA Wealth Partners. "The only knowable impact is on energy markets, so positioning means extended inflation fears."

INVESTORS USE 2022 PLAYBOOK

"Investors are basically going back to the 2022 energy-shock template. That is very fresh in our minds. We saw how large and persistent the inflation shock was," said Rohan Khanna, head of euro rates strategy at Barclays, referring to the initial impact of Russia's full-scale invasion of Ukraine.

The selloff was also exacerbated because investors had previously been positioned for bonds to rally on worries about AI-driven disruption to the underlying economy, Khanna said.

Europe imports the bulk of its oil and gas. Prices have surged as shipping through the Strait of Hormuz, which carries around one-fifth of oil consumed globally and large quantities of liquefied natural gas, has ground to a near halt.

Brent crude rose 2.5% to $80.31 a barrel on Tuesday, after earlier reaching $85.12, the highest since July 2024. LCOc1 Benchmark European wholesale gas prices closed around 35-40% higher on Monday, and were up more than 40% again on Tuesday. O/RNG/EU

U.S. Treasury yields also jumped on Monday and Tuesday on concerns that prolonged conflict could strain fiscal budgets and as some investors — including foreign holders — sold bonds to boost liquidity, said Jan Nevruzi, rates strategist at TD Securities.

"It's a dash for cash," Nevruzi said. "People are trying to get their hands on pure liquidity."

MARKETS PUSH BACK RATE CUT EXPECTATIONS

The Bank of England is due to meet later this month and policymakers are divided over whether to prioritise inflation or growth.

Traders see just a 30% chance of a cut, versus 75% on Friday. 0#GBPIRPR

Markets no longer fully price a Fed cut until September, out from July. Traders price a 17% chance of an ECB hike by year-end, compared to around a 40% chance of a cut last week. 0#EURIRPR

Euro zone inflation rose more than expected to 1.9% year-on-year last month, data on Tuesday showed, while a market gauge of euro zone inflation over the next two years jumped to just over 2% on Tuesday, from around 1.8% on Friday. EUCPIZ2Y=TWEB

Analysis by the ECB suggests that a permanent oil price spike of this magnitude could lift inflation by 0.5 percentage points. The ECB is likely to say it is too early to tell what impact the conflict will have when it meets later in March, Pictet Wealth Management's head of macroeconomic research Frederik Ducrozet said.