German two-year bond yields, which are particularly sensitive to interest rate expectations, were flat at 2.77% but were still on course for a 22-basis-point increase in July.
U.S. two-year Treasury yields rose 1.5 basis points (bps) to 4.24% and were set for a monthly rise of 10.5 bps.
However, long-dated bonds underperformed in July, sending their yields sharply higher as investors began to assess the implications of a prolonged conflict in the Middle East, including the prospect of increased fiscal spending, larger budget deficits and a rising debt burden.
“It’s not just inflation. For markets, more geopolitical tensions translate into concerns about increased defence spending and possible government support measures to offset the impact of a potential energy crisis,” said Massimiliano Maxia, fixed income specialist at Allianz Global Investors.
Germany's 10-year bond yield fell 1.5 bps to 3.15%, still on track for a 28-bps increase this month.
The benchmark U.S. 10-year Treasury yield slipped 1 bp to 4.65% and was on course to end July about 22.5 basis points higher.
Investors expect more rate volatility in the U.S. in the absence of forward guidance from the Fed. U.S. 30-year Treasury yields climbed to a 19-year high on Thursday as investors sought protection against future inflation risks.
“High correlations between the U.S. rate volatility and foreign bond levels suggest a clear cross-border transmission mechanism,” said David Tam, U.S. rates strategist at BNY.
“In particular, developed market sovereign bonds, which are more closely integrated with the U.S., could see a selloff and yield spike in a rising U.S. rate volatility environment.”
U.S. 30-year Treasury yields US30YT=RR were last down 2.5 bps at 5.18%, after reaching 5.2444% on Thursday.
Japan borrowing costs steady after BoJ holds rates
Japan’s borrowing costs were little changed with the 10-year bond flat at 2.79% JP10YT=JBTC after the Bank of Japan kept interest rates steady, signalling further rate hikes.
“Those in the forex or bond markets looking for some BoJ support for the yen or the long end of the Japanese government bonds (JGB) market will be a little disappointed, rather than surprised,” said Chris Turner, global head of markets at ING.
“There seems little urgency for the BoJ to accelerate its tightening cycle.”
Euro zone and U.S. yields on track for biggest monthly rise since March
Euro zone and U.S. bond yields were on track on Friday for their biggest monthly rise since March, with long-dated borrowing costs rising faster than those at the short end as investors focused on the longer-term implications of the conflict in the Middle East.
Bond yields edged lower on Friday along with oil prices as more supplies flowed through crucial maritime chokepoints, despite a lack of major breakthroughs in talks between the United States and Iran.
Money markets indicated a more hawkish interest rate outlook on both sides of the Atlantic this month, fuelling a bond selloff and pushing yields higher as the conflict in the Middle East reignited inflation fears.
Traders returned to fully pricing a European Central Bank depo rate at 2.75% by March 2027, a level last seen at the height of the Iran conflict, while quickly scaling back expectations for Federal Reserve rate cuts.
The ECB raised interest rates to 2.25% in June before pausing this month, while the Federal Reserve has remained on hold and is expected to deliver two rate hikes by June next year, with a first move in October almost fully priced in by markets.
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