Euro zone bonds recover slightly as oil prices retreat from highs

By Niket Nishant

LONDON, March 9 (Reuters) - Germany's 10-year bond recovered from a sharp selloff on Monday as oil prices retreated from their highest level since 2022, although fears of a prolonged fallout from the widening war in the Middle East kept investors on edge.

Investors have largely looked past the safe-haven appeal of global bonds, focusing instead on inflation risks as the U.S.-Israel war on Iran disrupts traffic through the Strait of Hormuz, a crucial oil shipping route.

Oil prices had surged to more than $119 a barrel in early trade on Monday, but edged back from their highs on expectations that G7 countries could release emergency oil reserves in an attempt to lower prices.

G7 nations held off from making a decision to release their reserves but said all tools were available to stabilise the market.

Germany's 10-year government bond yield DE10YT=RR, the bloc's benchmark, was little changed at 2.863%. It hit 2.931% earlier, its highest level in a year, and is still up over 40 basis points (bps) since the outbreak of the war.

The supply shock has lifted crude prices by about 40% since the first wave of attacks on Iran, threatening the inflation outlook.

Capital Economics said that a useful rule of thumb is that a 5% rise in oil prices adds around 0.1 percentage points to developed market inflation.

"One after another, geopolitical catastrophes that kept scenario planners awake for decades have delivered smaller-than-expected (oil) price spikes. But a Strait of Hormuz shutdown is a big deal," said Kevin Book, an expert at the Center for Strategic and International Studies.

RATE OUTLOOK MUDDLED

Higher crude prices have compounded investor unease about the rate outlook for central banks, reviving the possibility of policy tightening.

A market-based measure of euro zone long-term inflation expectations jumped as high as 2.2658%. It was last at 2.1459%. EUIL5YF5Y=R

Money market traders have moved to fully price in one quarter-point rate hike from the European Central Bank in 2026, with around a 25% chance of a second. Prior to the conflict, markets had priced about a 40% chance of a rate cut by year-end.

The yield on Germany's interest-rate-sensitive two-year bond DE2YT=RR rose 2 bps to 2.330%, having earlier reached 2.476%, a level last seen in August 2024.

The risk of higher borrowing costs is particularly acute in countries reliant on energy imports, such as Britain. The yield on the two-year British government bond GB2YT=RR jumped as high as 4.239%, although it was last at 3.985%.

TS Lombard economist Dario Perkins expects that central banks planning to leave rates on hold will probably stick to that plan, but those planning to cut face the biggest headache.

"Inflation is already overshooting their targets, and – in their minds – that makes expectations 'more fragile'," Perkins said. "For now, all rate cuts have been postponed."

U.S. President Donald Trump said the U.S. Navy could escort ships in the Gulf. However, it remains unclear whether the Navy has the capacity to do so, as some of its vessels are currently conducting strikes against Iran and intercepting its missiles.

Iran has named Mojtaba Khamenei to succeed his father Ali Khamenei as supreme leader, defying Trump and underscoring hardliners' grip in Tehran.