(Bloomberg) -- Treasuries fell, sending 30-year yields to the highest since July, as traders boosted wagers that the Federal Reserve will have to reserve course and raise interest rates to curb inflation following a surge in oil prices.
Yields increased by at least five basis points across the curve on Monday, with 30-year rates rising as high as 5.03%. Two-year yields, which are the most sensitive to shifting expectations for Fed policy, climbed as much as 11 basis points to 3.99%.
Interest-rate swaps showed traders have priced in about a 70% chance of a Fed rate hike by April 2027. That marked a sea-change from before the Iran conflict started in late February when traders had expected a series of cuts.
The bond-market moves came amid a jump in Brent crude prices after critical energy infrastructure and tankers in the Middle East came under attack. Elevated prices for crude have become a principal driver of bond yields globally, altering the outlook for inflation and leading traders to abandon forecasts for Fed interest-rate cuts this year.
Economists at Barclays Plc on Monday changed their Fed forecast to just one cut by the end of next year, in March 2027, citing the outlook for energy prices. They had previously expected a cut in September 2026 as well. Morgan Stanley economists made a similar shift last week.
"When you look at what the bond market's pricing in, there's a little more concern as it relates to inflation and how long-lasting this conflict will be," said Andrew Szczurowski, a portfolio manager at Morgan Stanley Investment Management.
On Monday, one of the standout flows seen in SOFR options has been a downside hedge looking to target additional Fed interest-rate hike premium to be priced by the end of the year.
European bonds also fell, with the German two-year yield rising as much as nine basis points to 2.73%. Traders also added to expectations of interest rate hikes by the European Central Bank this year, with a move in June fully priced and more than 80 basis points in total seen through this year.
The Fed last week kept the key benchmark rates steady in a range between 3.5% and 3.75%. But three officials dissented over the policy statement, saying it was no longer appropriate to signal that the Fed's next move was still likely to be an interest-rate cut.
New York Fed President John Williams was among the officials who have maintained their easing bias. He said Monday that interest rates will need to come down "at some point" if inflation returns to the US central bank's 2% target, as he expects.
In addition to monitoring the Middle East turmoil, bond traders are looking ahead to the US government's announcement on Wednesday of its quarterly financing plan, in which it customarily provides guidance on the sizes of its note and bond auctions through July.
While the previous announcement in February reiterated the outlook for unchanged auction sizes "for at least the next several quarters," investors and strategists expect the guidance to have changed because increases may be needed sooner.
Traders will also scrutinize a key labor market report on Friday, which economists expect to show that the unemployment rate held steady at 4.3% in April and that payroll growth slowed.
Szczurowski said he has increased his holdings of shorter-term notes, arguing that the labor market will cool in the coming months and allow the Fed to resume policy easing. He added that he remains wary of long-term bonds amid uncertainty over the fiscal outlook.
"I don't think the Fed's going to cut over the next couple of months or even the next quarter or two," he said. "But it's not going to take them off the table completely."
Nohshad Shah, head of EMEA fixed-income sales at Citadel Securities, said he remains optimistic that the Iran conflict is coming to an end, which will support both the fixed-income and stock market "in the short-term."
The risk, however, is that higher oil prices, in an economy with a "robust"growth outlook, feed into broader inflationary and inflation expectations pressures, a scenario that both central banks and markets may be underestimating, he wrote in a client note.
"Upcoming jobs data in coming months will determine if this changes enough to justify a more hawkish shift that would put a spanner into the works for risk assets," Shah wrote.
--With assistance from Edward Bolingbroke.
(Updates with pricing and comments throughout.)
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