Global bonds battered as flaring inflation spooks investors

LONDON/NEW YORK, May 15 (Reuters) - Bond markets are bracing for interest-rate pain in a way they haven't in decades, as investors assess the economic costs of the war with Iran and how the global economy will bear those burdens.

U.S. Treasury yields hit their highest in around a year on Friday, two days after the government sold 30-year bonds at the highest yield since 2007, as traders anticipated the Federal Reserve would be forced to hike rates to rein in inflationary pressures stemming from energy shocks. Major global stock indexes were down between 1% and 2%, a day after the S&P 500 and Nasdaq hit new highs.

Investors said the broad selloff reflected a week of high inflation readings and the realization that the war in Iran was likely to continue to stoke higher energy prices, following a meeting between the U.S. and China that yielded no significant headlines on the Middle East situation. Brent crude rose 4% to exceed $109 a barrel.

"There is a real fear that inflation is kind of embedded in the economy going forward," said Peter Tuz, president of Chase Investment Counsel in Charlottesville, Virginia. "You don't see any signs of it going down right now, and that is a real fear, and it will drive the market down if it continues."

Friday's market swings also reflected a sense among many investors that trading in U.S. stocks had grown disconnected from global economic fundamentals, due to excitement driven by the surging corporate profits tied to artificial intelligence investments.

U.S. indexes have surged back to record highs in the month-and-a-half since the markets' Iran war scare bottomed out at the end of March, a surge that raised eyebrows because it seemed at odds with sharply higher energy prices and related disruptions.

"There's a realization that the market had gotten way ahead of itself," said Kenny Polcari, chief market strategist at Slatestone Wealth Management in Jupiter, Florida. "It wasn't paying enough attention to what the bond market and economic data is telling it. It was caught up in this momentum AI trade."

BOND YIELDS RISING EVERYWHERE

Though the bond rout was sweeping the globe, many of the drivers were at least partly local in nature. UK gilt yields surged again, hitting their highest in decades, as pressure mounts on Prime Minister Keir Starmer to resign over his Labour Party's hefty losses in local elections, and as challengers emerge.

Yields across the euro zone jumped, while Japanese bond yields hit record highs following a red-hot wholesale inflation reading this week that investors believe is likely to lead to rate increases from the Bank of Japan.

Italian 10-year bonds were among the worst performers, with yields up 11 basis points to around 3.89%, bringing the rise for the week to 16 bps, while benchmark German Bund yields rose almost 7 bps to around 3.12%, up 11 bps this week.

The selling pointed to an inflation-driven change in market sentiment, with increasing scrutiny of government spending and related issues.

"The political turmoil in the UK has pushed gilt yields higher and called into question fiscal sustainability there. You have a tendency to say there's a problem in the UK, who could be next," said Eric Winograd, chief U.S. economist at AllianceBernstein. "Japan could be next, the U.S. could be next. As we roll into the midterms it's entirely possible we get new fiscal policy but we haven't seen anything here that would drive this."

ARE THE VIGILANTES ON THE PROWL?

When global bond markets get rattled, talk often turns to the "bond vigilantes," the fixed-income investors who decades ago were said to have forced governments to cut spending by demanding higher yields. While the turmoil in U.K. and Japanese markets shows signs that these dynamics could re-emerge, investors said this week that the acute issue is how high energy prices and rising inflation readings will play out at central banks.

Inflation data this week has shown consumers and businesses are starting to see big increases in price pressures as a result of the war, which has pushed up the price of crude oil by more than 50%. Investors have been betting on a Federal Reserve rate cut, but those wagers have almost fully reversed, with the markets showing a nearly 50% likelihood the central bank will raise rates this year.

Two-year yields, which are the most sensitive to changes in expectations for inflation and interest rates, have risen most sharply this week, but yields on longer-dated bonds have started to increase as well, reflecting investors' concern about the longer-running impact from a price shock. The rates market also shows that just four out of 24 of the world's most influential central banks have any meaningful chance of delivering a rate cut this year, with the vast majority tilted in favour of hikes, according to LSEG data.

"Global yields have probably come to the point where they are high enough to hurt sentiment," DBS senior rates strategist Eugene Leow said.

(Additional reporting by Rae Wee in Singapore, Twesha Dikshit in Bengaluru, Sinead Carew and Caroline Valetkevitch in New York and Matt Tracy in Washington; Editing by Alex Richardson, Colin Barr and Daniel Wallis)

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