Global bond rout deepens with concern over war-driven inflation

By Lewis Krauskopf, Gertrude Chavez-Dreyfuss and Dhara Ranasinghe

NEW YORK/LONDON, March 20 (Reuters) – Government bond yields in the United States and Europe spiked on Friday as investor concern intensified over the inflationary impact of the Iran war-driven global energy shock, with expectations that the pressure will not ease anytime soon.

Investors are rapidly recalibrating the ability of central banks globally to ease monetary policy the longer the war goes on. The jump in oil prices has upped the odds that the U.S. Federal Reserve may need to tighten borrowing ​costs.

“Expectations for a rate cut are fading fast,” said Robert Pavlik, senior portfolio manager at Dakota Wealth Management. “You need to get the Strait of Hormuz opened up and you ‌need to get oil flowing, and that would relieve the pressure on oil prices.”

In the United States, 10-year rates rose to their highest since last summer. Investors, long focused on the prospect of further interest-rate cuts this year, shifted to pricing in a moderate chance that the Fed will be forced to hike later this year. Investors across markets closely watch bond yields because they help set prices that underlie corporate borrowing and mortgages.

Sharp increases in those prices can hit both economic growth and asset pricing. U.S. stocks tumbled on Friday, sending the S&P 500 to its fourth straight weekly decline for the first time in a year and leaving the Nasdaq down 2% on the day, just above the level ‌that would ​confirm a correction marking a 10% decline from a recent peak.

British 10-year government borrowing costs also soared, rising to their highest level ⁠since the global financial crisis. The 10-year gilt yield pushed ⁠above 5%, widely seen as a pressure point reflecting Britain’s economic vulnerability to rising energy costs.

German 10-year government bond yields hit their highest since the euro zone crisis in 2011. The 10-year yield, a benchmark for European government borrowing costs, hit a high of 3.025%. Yields rise as prices fall and vice versa.

ECB policymakers warned of growing inflation risks on Friday, but stopped short of calling for tighter policy, even as a host of brokerages started penciling in rate hikes from as soon as April.

Most of the big G10 central banks, including the Federal ​Reserve and Bank of England, held policy meetings this week and sounded a similarly cautious note on inflation risks.

On Friday, three U.S. officials told Reuters that thousands of additional Marines and sailors are being deployed to the Middle East, with plans to depart the U.S. about three weeks ahead of schedule, according to one of the officials.

Later, Iraq declared force majeure on foreign-owned oilfields due to the ⁠Strait of Hormuz disruption, referring to a notice used to describe events outside the declarer’s control that usually release it ⁠from contractual obligation without penalty.

“Nothing positive has happened so far with respect to the war and we’re heading into the fourth week, and we’re probably ​going to have a further build-up of these pressures,” said Padhraic Garvey, head of global rates and debt strategy at ING in New York.

‘MUCH MORE PROTRACTED’

Fed Governor Christopher Waller said on Friday he had planned to ​dissent in favor of a rate cut at this week’s meeting of the central bank because of unexpected job losses in February, but the oil ‌shock and the threat of more persistent inflation convinced him a more cautious approach is needed until the impact of the Iran war becomes clearer.

“This is looking like it’s going to be a much more protracted conflict, and oil prices are going to stay high for a longer time,” Waller said on CNBC’s Squawk Box.

U.S. rate futures on Friday began to price in the possibility of an interest rate hike later this year, with markets assigning a 32% chance of tightening by November, according to LSEG estimates, up from virtually zero late on Thursday.

Two-year bonds around the world have been the most prominent victims of inflation ⁠fears. In Britain, short-dated gilt yields rose by more than 30 basis points at one point on Thursday as prices tumbled. Two-year German Schatz yields ended the day up 12 bps at 2.566%, having hit nine-month highs. By Friday, they were up 3 bps at 2.6%.

Prior to the conflict, markets showed traders were attaching a roughly 40% chance to another ECB rate cut this year. That has ⁠now flipped to one hike almost fully priced for June and a 60% ‌chance of one in April.

Some investors were paying more attention to the potential impact of government efforts to contain the economic damage. Spain’s ⁠government on Friday proposed measures worth 5 billion euros ($5.8 billion) to counter the economic impact of the Middle East conflict on local energy prices.

“A ​lot of attention ‌today has been on fiscal policy,” said George Moran, European macro strategist at RBC Capital Markets in London.

Italian 10-year bond yields were up ​6 bps at 3.846%, ⁠having risen on Thursday by as much as 12 bps at one point. Given Italy’s greater dependence than many of its neighbors on imported energy, its bonds have come under more pressure since the start of the war in late February.

Italy’s benchmark BTP yields have risen nearly 60 bps since then, compared with a 45-bp rise in French and Spanish yields and a 34-bp rise in German Bund yields, which has brought the gap between those two – one market indicator of risk aversion – to nearly 80 bps, its widest since last October.

“The sad fact is there are significant upside risks to inflation and therefore the selloff makes sense,” said Chris Scicluna, head of research at Daiwa Securities in London. “The repricing of the path of interest rates, at least in Europe, looks reasonable in light of the shock to energy prices.”

(Writing by Colin Barr; ​Editing by Megan Davies, Will Dunham and Andrea Ricci)