By Alun John and Yoruk Bahceli
LONDON, March 3 (Reuters) - Government bond markets from the euro zone to the United States and Britain sold off sharply on Tuesday as the air war in the Middle East drove oil and gas prices higher and rekindled inflation fears.
Sustained higher inflation would likely force central banks to turn more hawkish, and traders slashed bets on near-term rate cuts from the Bank of England and Federal Reserve, while shifting to price a small chance of a European Central Bank hike
by year-end.
Chief Economist Philip Lane told the Financial Times in an interview that a prolonged war in the Middle East could cause a substantial spike in euro zone inflation and reduce economic growth.
The price of rate-sensitive two-year notes tumbled globally, sending their yields surging.
Britain's two-year gilt yield rose 15 basis points to 3.79%, bringing the increase since Friday's close to 27 bps, set for its biggest two-day jump in nearly a year and a half.
German two-year yields rose 10 bps on Tuesday and are up 17 bps since Friday, the most since July, and U.S. two-year yields were up 6 bps on the day.
INVESTORS USE 2022 PLAYBOOK
"Investors are basically going back to the 2022 energy-shock template. That is very fresh in our minds. We saw how large and persistent the inflation shock was," said Rohan Khanna, head of euro rates strategy at Barclays, referring to the initial impact of Russia's full scale invasion of Ukraine.
He said bond market moves were due to the jump in energy prices, but the selloff was exacerbated by the fact that investors had previously been positioned for shorter-dated yields to fall on worries about AI-driven disruption to the underlying economy.
Europe imports the bulk of its oil and gas. Prices have surged as shipping through the Strait of Hormuz, which carries around one-fifth of oil consumed globally as well as large quantities of liquefied natural gas, has ground to a near halt.
Brent crude rose 6% to $82.40 a barrel on Tuesday. Benchmark European wholesale gas prices closed around 35-40% higher on Monday, and were up another 36% on Tuesday. [O/R] [NG/EU]
Benchmark 10-year yields also surged, with Britain's up 16 bps to 4.53%, Germany's up 9 bps to 2.80% and the U.S. up nearly 5 bps to 4.10%.
HOW LONG WILL IT LAST?
The selloff was most dramatic in Britain, where the BoE is due to meet later this month. Policymakers are sharply divided over whether to prioritise inflation, or economic growth.
Traders feel the latest inflation worries could shift the balance at least at this month's meeting, and now see around just a 25% chance of a cut, versus 75% on Friday.
Elsewhere, markets are now not fully pricing a Federal Reserve rate cut until September. With the ECB, traders are now pricing in a small chance of a hike by year-end, having placed a roughly 40% chance on a cut late last week
Euro zone inflation rose more than expected to 1.9% year on year, last month, data on Tuesday showed, while a market gauge of euro zone inflation over the next two years jumped to just over 2% on Tuesday from around 1.8% on Friday.
Analysis by the ECB suggests that a permanent oil price spike of this magnitude could lift inflation by 0.5 percentage points.
Monetary policy acts with long lags and is considered powerless against near-term swings in prices, so the focus for policymakers will be how long energy prices remain elevated and whether that has second-round effects on wages and prices of other goods.
"It's too early to tell (the economic impact of the conflict) and that's going to be the official line - if I have to guess - into the next (ECB) meeting," Frederik Ducrozet, head of macroeconomic research at Pictet Wealth Management, said.
"But also it's also true that they have to be careful in case you really face a sustained oil shock," he added.
(Reporting by Alun John and Yoruk Bahceli, Editing by Louise Heavens, Dhara Ranasinghe and Amanda Cooper)
