Updates with comment on government policy options, bond yield chart

By Alun John, Amanda Cooper and Matt Tracy

LONDON, May 18 (Reuters) - Investors are waking up to the worry that war in Iran may deliver a lasting inflationary shock, with sovereign bond yields racing to decade highs and threatening a severe hit to the spending power of governments, businesses and households.

The average rate at which governments in the Group of Seven richest nations pay to borrow for 10 years is approaching 4%, up from around 3.2% before the war started in late February, while 30-year borrowing costs have risen to 4.6% from 4%.

The risk of longer-lasting inflation has ignited concern that central banks will need to quickly raise interest rates, potentially amplifying economic fallout.

"It feels like a bit of a perfect storm at the moment," said Tom Ross, head of high yield at Janus Henderson, which oversees about $493 billion. "The rates market has been grappling with the idea of inflation caused by strains from the Middle East and oil. And on the other side, especially in conjunction with that, any demand destruction that comes through from those high commodity prices."

GOVERNMENTS' DEBT FINANCING PAIN

Here are some related stories on the impact of higher government bond yields, what's behind them and why politicians might worry:

- Under Pressure Tracking the pain in G7 government debt

- Who are the 'bond vigilantes' exacting a price from Britain's government?

- How bond market vigilantes could check Trump's power

BIG MOVE IN YIELDS

Benchmark 10-year U.S. Treasury yields US10YT=RR jumped as much as 3.6 basis points to their highest since February 2025 at 4.631%, before moderating to trade at 4.6%. The 30-year yield US30YT=RR, which directly impacts mortgages, rose to a one-year high of 5.159%. Yields rise when bond prices fall.

Wall Street's main stock indexes were modestly lower on Monday after declining on Friday, with some investors warning that record-high U.S. stock markets have not yet priced in the risk of rising inflation.

Markets were pricing in a roughly 50% chance the U.S. Federal Reserve will raise rates by December, marking a reversal from expectations prior to the Iran war, which factored in at least one rate cut this year.

U.S. overnight funding markets remained stable on Monday, displaying little of the stress that pushed Treasury yields sharply higher late last week.

The tri-party general collateral rate, which measures the cost of borrowing short-term cash using Treasuries as collateral, was quoted at 3.55%, little changed from Friday.

A recent drop in Treasury bill issuance, combined with the Federal Reserve’s reserve management purchases, has reduced bill supply to early-May lows, boosting bank reserves and leaving short-end collateral scarce amid ample system liquidity.

G7 FINANCE LEADERS MEET IN PARIS

Market ructions are top of mind for G7 finance ministers who met in Paris on Monday.

"We are no longer in a period where public debt is not a subject," French Finance Minister Roland Lescure told reporters as he arrived at the meeting.

The question of what policymakers can do in an age of surging government debt alongside rising bond yields is one that markets have taken up in recent days.

“If the administration becomes uncomfortable with yields, they have a handful of levers they can pull,” said Eric Winograd, chief U.S. economist at AllianceBernstein in New York. “One is fiscal commitment. So you can reinforce the idea of fiscal credibility.”

Winograd added, “The central bank can try to do something. In the U.S. there is a new Fed chair coming in and another policy meeting next month. If you want to bring Treasury yields down, you should come in and be hawkish,” potentially easing market nerves and making rate increases unnecessary.

DIFFICULT MATH FOR GOVERNMENTS

The pattern is the same across major bond markets, from the euro zone to Britain and Japan, where yields are at record highs. Central banks set interest rates, but bond markets set the rate at which companies, individuals and governments can borrow, meaning that anything from a car loan to financing for a multi-billion-dollar data centre is affected.

Kenneth Broux, head of corporate research, FX and rates at Societe Generale, said to stop what he called a "slow-motion crash" in the bond market would require a retreat in oil prices, recession fears growing enough to spark a safe-haven rush to bonds, or prices falling low enough to attract buyers.

Yields on the 30-year Japanese government bond (JGB) jumped to their highest on record at 4.200% JP30YTN=JBTC while 10-year yields JP10YTN=JBTC touched their highest since October 1996 at 2.800%. Japan plans to issue fresh debt as part of funding for a planned extra budget to cushion the economic blow from the war.

Euro zone bond yields edged lower in afternoon trading in Europe, but were still at their highest in years. German 10- year Bund yields, the benchmark for the currency bloc, hit a 15-year top of 3.193% DE10YT=RR, up 10 bps in a week.

Yields on bonds issued by more indebted countries such as Italy IT10YT=RR and France FR10YT=RR have risen even more sharply. Ten-year Italian government borrowing costs are now at 3.90%, up 12 bps in a week, while French yields FR10YT=RR have risen 26 bps.

INFLATIONARY PRESSURES COMING THROUGH

Bonds sold off steeply last week as investors were spooked by a recent raft of hotter-than-expected inflation figures globally, particularly in the United States.

"The fact that we are now seeing data backing up inflationary fears that have been in the market since the Middle East conflict started I think is key," said Nick Twidale, chief markets analyst at ATFX Global.

Data last week showed U.S. consumer and producer prices surged in April, with similar readings seen in China, Germany and Japan.

Though the bond rout was global, some markets also faced local pressures.

An uncertain future for UK Prime Minister Keir Starmer is raising investor fears he will be forced out and replaced by a less fiscally prudent challenger.

On Monday, however, UK gilts were an outperformer, with the 10-year yield down 4 bps to 5.14%. They rose by 27 bps last week and are still the worst-performing 10-year bonds in the developed world GB10YT=RR since the war started.