Bond markets in both the euro zone and the United States are finishing July with their biggest monthly rises since March, as investors reassess the inflation and interest rate outlook in light of the ongoing conflict in the Middle East. The situation has pushed longer-dated borrowing costs higher relative to short-term yields over the month.
Market participants cited concerns that a prolonged conflict could lead to increased government spending, wider budget deficits and higher sovereign debt burdens - all factors that can stoke inflationary pressures and influence central bank decisions.
On Friday, both sovereign yields and crude oil prices eased after reports that additional supplies were moving through key maritime chokepoints. At the same time, talks between the United States and Iran produced no substantial progress, leaving uncertainty about the conflict's near-term trajectory.
Money market pricing reflected a more restrictive policy path on both sides of the Atlantic over July, with renewed inflation worries climbing back onto investors' radars. Traders are now fully pricing a European Central Bank deposit rate of 2.75% in early 2027 - a level that was last reached during the peak of the Iran conflict.
The ECB raised its deposit rate to 2.25% in June before pausing in its subsequent meeting this month. The Federal Reserve has kept its policy rate on hold and market-implied expectations point to two rate hikes by June next year, with an October move almost fully priced in by traders.
Short-term German debt, which tends to be sensitive to rate expectations, saw two-year yields dip 0.5 basis points to 2.76% on Friday. Despite that small decline, those yields remained on course for a 22-basis-point increase over July.
In the United States, two-year Treasury yields were unchanged at 4.23% and were poised for a monthly gain of 9 basis points. On the longer end of the curve, Germany's 10-year yield fell 1.5 basis points to 3.15% on Friday but was tracking toward a 28-basis-point rise for the month.
The move this month underscores how geopolitical developments can quickly alter inflation expectations and the path of interest rates, influencing both government borrowing costs and broader financial conditions.
Summary
Yields in the euro zone and US are set for their largest monthly increase since March as markets price in higher inflation and tightened monetary policy risks stemming from the Middle East conflict. Long-term borrowing costs rose more sharply than short-term rates in July. Friday saw a pullback in both bond yields and oil after increased flows through key maritime chokepoints and limited progress in US-Iran talks.
Key points
- Euro zone and US bond yields are headed for the biggest monthly increases since March, driven by Middle East tensions and inflation concerns.
- Long-dated yields climbed faster than short-term rates in July as investors factored in potential for greater fiscal spending, larger deficits and higher debt levels.
- Markets now fully price an ECB deposit rate of 2.75% in early 2027; the ECB had raised rates to 2.25% in June then paused. The Fed has held rates and markets expect two hikes by June next year with an October move nearly fully priced.
Risks and uncertainties
- Prolonged conflict in the Middle East could elevate inflation and push central banks toward tighter policy - impacting government borrowing costs and financial markets.
- Higher fiscal spending and widening deficits in affected economies could increase sovereign debt burdens and influence long-term yields.
- Diplomatic progress remains limited: no major breakthrough emerged from US-Iran discussions, leaving the outlook for supply disruptions and energy prices uncertain.