Global bonds battered as flaring inflation spooks investors

By Amanda Cooper and Karen Brettell

LONDON/NEW YORK, May 15 (Reuters) - Stock and bond markets around the world limped to the end of a bruising week on Friday, reflecting an investor scramble to position for rising interest rates as global economic growth slows under the weight of Iran war-related economic damage.

U.S. Treasury yields hit their highest in around a year as traders anticipated the Federal Reserve would be forced to hike rates to rein in inflationary pressures stemming from energy shocks. U.S. stock indexes opened around 1% lower, extending losses around the world highlighted by declines of 2% in Germany and 1.8% in Britain.

Investors said the broad selloff reflected the realization that the war in Iran was likely to continue to weigh on economic output around the world, following a meeting between the U.S. and China that yielded no significant headlines on the Middle East situation.

"We expected more out of the meeting in China with Trump and it didn't seem like there was much progress made in terms of the outcome in the Middle East, and so oil's backing up again," said Mike Sanders, head of fixed income investments at Madison Investments in Madison, Wisconsin.

The market was "expecting maybe a resolution somewhere down the line but now that timeline's extended a little bit."

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.

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.

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."

PRICE PRESSURES INCREASING

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%.

"We see a reset of this global bond risk premium because the market is just realising we're living in a much more volatile inflation climate," Daniel von Ahlen, senior macro strategist at GlobalData TS Lombard, said.

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.

"Global yields have probably come to the point where they are high enough to hurt sentiment. Between a resilient global economy powered by AI build-out and elevated energy prices, central banks are probably more worried about inflation," DBS senior rates strategist Eugene Leow said.

Money markets show traders see a 60% chance of the Fed delivering a rate hike this year. Before the war, at least two cuts had been priced in.

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.

"It's not just inflation, but also higher deficits that should be the focus," Jefferies strategist Mohit Kumar said.

"We are likely to see a number of support measures for fuel subsidies announced in the coming months."

Kumar said he anticipated a steepening bias in government bond curves, referring to a market dynamic in which longer-dated bond yields rise more quickly than those of shorter maturities.

Ten-year yields across the G7 nations have risen by an average of 17 bps this week, compared with an average rise of 12 bps for two-year G7 debt yields.

Benchmark 10-year Treasury notes were last yielding 4.58%, up 12 bps on the day and around their highest since last June.

Benchmark 10-year gilts, which have risen by over 20 bps this week, were up another 15 bps at 5.14% on Friday, while 10-year Japanese yields closed up 7 bps at 2.7%.

(Additional reporting by Rae Wee in Singapore and Twesha Dikshit in Bengaluru; Editing by Andrew Heavens, Kirsten Donovan, Colin Barr and Alex Richardson)