July 20 (Reuters) - U.S. Treasury bond yields ticked higher on Monday, but were still headed for their sharpest week-on-week decline this month after softer-than-expected inflation readings last week prompted investors to scale back their bets on an imminent rate hike.

The 2-year yield US2YT=RR, which tracks near-term Federal Reserve policy expectations most closely, traded near 4.183%, slightly below its highest level since February 2025. The yield has fallen nearly 8 bps since last Monday, making this its largest week-on-week drop since June 29.

The yield on the benchmark U.S. 10-year Treasury note US10YT=TWEB edged up 1 basis point to 4.558%, about 8 bps off its July 14 high, as prices have risen.

Money markets currently expect the Fed to hold rates at 3.50%-3.75% at its July 28-29 meeting. Prior to data last week showing consumer and producer prices increased less-than-expected in June, traders saw a 40% chance of an interest rate hike.

For the rest of the year, traders have fully priced in one 25- basis- point hike from the Fed and see roughly a one-in-three chance of a second quarter-point increase.

Inflation expectations have been dropping almost uninterruptedly this month. A market-based measure of inflation in a year's time fell below the Fed's target rate of 2% for the first time since October 2024 last week - just as the oil price was breaking above $85 a barrel. O/R

"It remains difficult to fully price out further Fed action, given still-elevated inflation, AI-driven demand pressures, and persistent hawkish rhetoric from Fed Chair Warsh," Barclays strategists said in a note.

"The risks seem to be toward pricing a prolonged expansionary cycle with stubborn inflation, whereby the Fed delivers more than calibration/credibility hikes, or a higher-for-longer world in which the Fed stays put indefinitely."

Oil prices crept back higher as prospects of a sustainable peace deal between U.S. and Iran receded. U.S. forces hit Iran for a ninth consecutive day on Monday, sparking worries about shipping supply through the Strait of Hormuz.

The U.S. economic docket is light this week and the Fed remains in a blackout period before its policy meeting next week.

U.S. 2-year Treasuries have outperformed the rest of the G7 complex by a wide margin, as investors price in a lower chance of the Fed raising interest rates, compared to a greater probability that other major central banks in energy-importing nations may be forced to do so.

In the last week, 2-year yields have fallen by over 8 basis points, compared with a rise of almost 8 bps in Italian 2-year yields IT2YT=RR, or a 5.5-bp rise in German yields DE2YT=RR.