Rising energy prices roil global bonds as traders tear up rate cut bets, wager on hikes

By Harry Robertson and Dhara Ranasinghe

LONDON, March 11 (Reuters) - Global bond markets were under heavy selling pressure on Wednesday, as the Iran war drove up oil prices and traders increased their bets that central banks would have to abandon rate cuts this year and instead consider hiking.

Short-dated bond yields - which are sensitive to interest-rate expectations - shot higher as bond prices tumbled in the euro zone and Britain. Yields also rose in the United States.

"What the rates markets are saying is that this war leads to a prolonged rise in oil, and the path that central banks are on will have to shift to a more hawkish one," said Seema Shah, chief global strategist at Principal Asset Management.

Energy prices have risen dramatically this week as flows through the vital Strait of Hormuz have slowed to a halt and Iran has hit its neighbours' exporting infrastructure.

U.S. President Donald Trump's statement that the war was "very complete" helped cool prices on Tuesday, but they were volatile on Wednesday and last up almost 5% following reports that vessels were struck by projectiles in the key Strait of Hormuz LCOc1.

Prices neared $120 a barrel on Monday and last traded at around $92, up over 25% since the start of the war.

Germany's 2-year bond yield DE2YT=RR rose 11 basis points, Britain's and Italy's jumped 14 bps and 12 bps, respectively, while those in the United States climbed 7 bps. Longer-dated bond yields also rose.

ECB OFFICIAL EYES HIKES

In the euro zone, comments to Bloomberg from European Central Bank member Peter Kazimir helped spark a renewed selloff in bonds after he said the war risked pushing the ECB to raise rates sooner than previously thought.

Other euro zone rate-setters also promised swift action if they thought inflation was at risk of getting entrenched, on the final day before policymakers enter their quiet period before the March 19 policy meeting.

Money market traders moved to fully price a rate increase by the ECB by July. Traders had previously seen a chance of rate cuts this year before the war broke out.

Germany's 2-year bond yield remained below the 19-month high of 2.476% hit on Monday. Germany's 10-year bond yield DE10YT=RR, the bloc's benchmark, rose 7 bps to 2.932%, the highest in a year.

Investors continued to monitor efforts to stabilise the oil market, including plans by members of the International Energy Agency to release 400 million barrels of oil from strategic reserves.

BRITAIN AND ITALY FEEL THE HEAT

The renewed rise in energy prices hurt Britain's volatile government bond market, with short-dated yields rising more than 14 bps GB2YT=RR to their highest since September.

Natural gas and oil make up a high share of British energy demand at around 35% each, according to the IEA, leaving Britain exposed to price rises.

Britain's government debt is almost 100% of GDP and bond markets remain scarred by the Liz Truss crisis of 2022.

Thinner liquidity, the ability to buy and sell an asset quickly, in the gilt market was exacerbating price moves, said Bryn Jones, head of fixed income at Rathbones.

"It has seemingly got worse since the start of the recent conflict. We had expected a rise in yields, but the moves have been aggressive," he said.

Italy - where government debt is more than 130% of GDP and which has similar oil and gas mix to Britain - saw its bonds hit harder than most of its euro zone peers.

British and European natural gas prices rose around 8%, ICE and LSEG data showed, and have jumped roughly 50% since the war started.

Italy's 2-year bond yield IT2YT=RR was last up 12 bps to 2.483%, although it remained off Monday's 14-month high of 2.646%.

U.S. short-dated borrowing costs also climbed US2YT=RR but the moves were less marked than those in Europe, in part reflecting the United States' position as an oil and gas exporter.

Still the U.S. economy is not immune from higher energy prices and American rate-cut bets have also been pared back.