The European Central Bank raised interest rates by 25 basis points on Thursday, in line with expectations, while lifting its inflation forecast and lowering its growth outlook. The move underscored growing concerns that higher energy costs could keep price pressures elevated for longer.

Read more: Global Market: Japan's Nikkei falls 3% as oil surge, US rate hike fears weigh

Markets brace for U.S. inflation data

Investors were awaiting U.S. consumer inflation data later on Friday, which could influence expectations for the Federal Reserve's policy decision next week. The Bank of Japan is also due to meet next week and is widely expected to raise borrowing costs.

Yields across government debt markets in the Group of Seven economies have posted their biggest weekly increases since the early stages of the war in late February. Short-dated bonds have come under particular pressure as investors have increased bets that central banks in Japan, the United States and Canada may need to raise rates to contain an inflation shock.

Read more: Global Market Today: Asian stocks, bonds fall on oil, inflation concern

Energy shock raises policy pressure

Attacks by U.S. and Iranian forces on targets around the Gulf, including tankers, have heightened concerns that the conflict could spread across the Middle East. Shipments through the Strait of Hormuz have slowed significantly, while oil producers including Saudi Arabia have begun cutting production.

The disruption has pushed energy prices higher and raised concerns that a prolonged supply shock could complicate central banks' efforts to bring inflation back toward their targets.

German yields hit multi-year high

Germany's two-year government bond yield rose another 3 basis points on Friday to 3.208%, its highest level since October 2023. The yield has climbed nearly 23 basis points this week, marking its biggest weekly increase since the first week of the war in early March.

Two-year yields across G7 economies have increased by nearly 25 basis points on average this week, while 10-year yields have risen almost 20 basis points. French 10-year yields have been among the biggest movers, increasing by about 25 basis points over the week.

The U.S. 10-year Treasury yield was also approaching 5%, a level last reached in October 2023 and previously seen in 2007.

Long-term debt comes under scrutiny

While short-term bonds have borne the brunt of this week's selling, investors are increasingly focused on longer-dated debt because those yields reflect expectations for inflation, economic growth and governments' long-term fiscal positions.

Reuters reported that investors have largely avoided longer-duration bonds since July, while market positioning remains heavily tilted toward higher rates. A softer-than-expected U.S. inflation reading could provide some relief to bond markets, particularly given the extent of recent bearish positioning.

ECB tightening bets increase

The ECB's outlook has become more hawkish after its latest rate increase. ECB President Christine Lagarde indicated that inflation could take longer than previously expected to return to the central bank's 2% target, with the latest projections pointing to a return only toward the end of 2027.

Reuters reported that sources familiar with the ECB's discussions now see further monetary tightening as increasingly likely, potentially as soon as the central bank's October 29 meeting.

Money markets are pricing in three additional ECB rate increases by March, with the possibility of a fourth hike by June.

French and Italian bonds also weaken

Benchmark 10-year German Bund yields, which have risen about 17 basis points this week, were last up 1 basis point on Friday at 3.5087%.

Elsewhere in the euro zone, Italy's 10-year government bond yield rose 1 basis point to 4.383%, while France's 10-year yield was little changed at 4.429%. French yields have risen about 24 basis points this week, their biggest weekly increase since mid-May.

The sharp rise in borrowing costs across major economies highlights the growing challenge facing central banks as they attempt to balance inflation risks stemming from the energy shock against slowing economic growth.

(Disclaimer: Recommendations, suggestions, views, and opinions given by experts are their own. These do not represent the views of The Economic Times.)

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