By Yoruk Bahceli, Ankur Banerjee and Gertrude Chavez-Dreyfuss

LONDON/SINGAPORE/NEW YORK, March 9 (Reuters) – Global bond markets tumbled on Monday as an intensifying U.S.-Israeli war with Iran pushed oil briefly toward $120 a barrel, heightening inflation concerns and fuelling expectations that European central banks could tighten policy later this year.

The markets stabilized a bit in the afternoon session, rallying from their lowest levels as oil prices came off their highs.

News that G7 finance ministers are prepared to implement “necessary measures” in response to surging global oil prices helped bring the oil price down from its earlier high. The G7 officials though stopped short of committing to release emergency reserves.

In the United States, the recent surge in oil prices has prompted investors to reduce expectations on the number of rate cuts from the Federal Reserve to just one 25-basis point reduction this year or none at all until 2027.

Brent crude prices on Monday soared to almost $120 per barrel – their highest since July 2022, but were last up 4.7% at around $97.

The U.S.-Israeli war with Iran is keeping the Strait of Hormuz, through which roughly one-fifth of the world’s oil and liquefied natural gas typically passes, virtually shut. 

Iran naming Mojtaba Khamenei to succeed his father Ali Khamenei as supreme leader also pressured prices, signaling that hardliners remain firmly in charge.

“If we’re seeing inflationary pressures building with oil prices going higher, there’s a potential that it constrains what global central banks can do for those looking to ease rates,” said Chip Hughey, managing director of fixed income at Truist Wealth in Richmond, Virginia.

“So we have seen the market reduce the chances of Fed rate cuts until well much later this year. There is a little bit more of a direct impact on Europe,” he added, noting a shift to rate hikes in the monetary policy outlook.

The spectre of rising inflation and the possibility of central banks needing to keep rates higher for longer or even hiking them has meant the safe-haven allure of bonds is being overlooked in the conflict.

BOND SELLOFF

On Monday, government bond yields surged further as prices tumbled, adding to last week’s dramatic moves. 

Investors moved to price in about 30 bps in rate hikes from the European Central Bank by year-end, a huge turnaround from February, when the risk was another rate cut. Earlier in the session, traders had priced as much as two full rate hikes.

For the Bank of England, traders now expect rates to remain roughly unchanged by the end of 2026. That’s still a big shift from expectations before the conflict of a cut this month.

Britain bore the brunt of rising borrowing costs. UK two-year yields rose to their highest in nearly a year, advancing by 40 bps. They ended up 6.2 bps at 4.04%.

In Germany, two-year yields touched their highest since July 2024 at 2.48% and were last up 1.3 bps. 

Those moves followed jumps of around 30 bps each last week, as European markets proved particularly vulnerable to the selloff given the region’s dependency on energy imports.

The moves were more muted in the United States, the world’s largest liquefied natural gas producer, where two-year yields were last up 3.4 bps at 3.59%. 

Longer-term bonds were mainly hit in Britain on Monday, where 10-year yields hit their highest since September last year.

STAGFLATION SCENARIO

Investors are growing more concerned about the inflation outlook. A market gauge of euro zone inflation over the next two years hit their highest since November 2023, while a similar measure in the United States — the two-year U.S. breakeven inflation rate — touched a one-month peak as of last Friday.

But analysts say bond market moves have also been exacerbated by positioning shifts as investors previously bet on steeper yield curves and falling short-term yields expecting central bank rate cuts.

Investors said that was hitting the UK particularly hard, where investors had previously been bullish in anticipation of rate cuts and easing fiscal concerns and were now unwinding those positions.

“What you are seeing right now is a huge capitulation,” RBC BlueBay Asset Management portfolio manager Kaspar Hense said.

While the market is pricing rate hikes from the ECB, Hense expects the bank to hold. 

“We would think that European growth will be hit to the same extent as inflation is rising… With that, we would think that it is more likely that the ECB looks through.”

Market focus was also on how governments may tackle the energy price surge, which will hurt consumers and businesses given its speed.

Governments in Asia are scrambling to limit the impact on economies and consumers, while the European Union is examining short-term measures to ease pressure on industry.

Credit ratings agency Fitch told Reuters on Friday that the finances of governments like Britain and France, already facing high budget deficits, could come under pressure if they launch new energy support measures.

For some analysts, the bond market reaction warranted caution for riskier assets. 

“Rates market repricing suggest a scenario where oil stays above $100 for months. But in that scenario we should see a much sharper repricing of the equity markets,” said Jefferies economist Mohit Kumar.

(Reporting by Yoruk Bahceli in London, Ankur Banerjee in Singapore, and Gertrude Chavez-Dreyfuss in New York; Editing by Sam Holmes, Dhara Ranasinghe, Toby Chopra, Philippa Fletcher and Deepa Babington)