(Bloomberg) -- Short-end Treasuries headed for a fourth day of declines on Friday as global benchmark oil prices above $100 a barrel reinforced fears of an inflation surge.
US two-year yields, which are among the most sensitive to monetary policy, climbed as much as 10 basis points to 3.89%, before paring the rise to 3.85%. Money markets have begun to price in a risk that the Federal Reserve will raise interest rates this year, abandoning their expectation from before the Feb. 28 start of the Iran war for two quarter-point cuts.
"The inflation backdrop is growing increasingly problematic for the Fed and rate cuts are not likely anytime soon," James Reilly, senior markets economist at Capital Economics, wrote in a note.
The Fed, European Central Bank and the Bank of England all held rates this week as policymakers grapple with the uncertain outlook for inflation and growth arising from the conflict in the Middle East. But officials are signaling to markets that they are ready to act soon if necessary to contain inflationary pressures.
The ECB will need to consider hiking interest rates as soon as next month if price pressures build further due to the Iran war, Governing Council member Joachim Nagel said on Friday. That followed BOE Governor Andrew Bailey's warning Thursday that policy must respond to the risk of a more persistent impact of the energy shock on prices.
Still, while bets on Fed rate cuts this year may have vanished, the chances of easing next year have increased, with swaps implying at least one quarter-point reduction by the end of 2027.
"A short-lived oil shock could potentially open up space for a cut in the fourth quarter under the next chair, while a more severe shock — especially one that tightened financial conditions — could actually lead to more rate cuts if accompanied by a weaker labor market," said Idanna Appio, portfolio manager and senior research analyst at First Eagle Investments.
Fed Governor Christopher Waller said on CNBC on Friday that caution was warranted given that elevated oil prices stand to feed through to core inflation, though he didn't rule out a rate cut later in the year. Vice Chair for Supervision Michelle Bowman, who along with Waller has previously signaled concern about a fragile labor market, said on Fox Business that it was too early to gauge the impact of the war and that she still envisions lower rates in 2026.
--With assistance from Malavika Kaur Makol.
(Updates prices in second paragraph and adds Fed officials' commentary in final paragraph.)
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