German government bond yields have climbed to their highest level since 2011, adding pressure to global bond markets. Meanwhile, despite the European Central Bank holding rates steady, traders are now betting on additional rate hikes this year.

Brent crude oil surged past $100 per barrel during ECB President Christine Lagarde's press conference, fueling inflation expectations. The 10-year German Bund yield rose as much as 4 basis points in a single day to 3.21%, while traders have fully priced in two rate increases from the European Central Bank this year.

The UK bond market is also under pressure from the recent spike in oil prices, with the 10-year gilt yield trading at 5.09%, approaching the 18-year high set in May. Traders are currently betting that the Bank of England will raise rates twice by year-end to 4.25%, followed by another increase to 4.5% by mid-next year.

Lagarde stated there are currently no signs of "second-round effects" from inflation but explicitly left the door open for a rate hike in September. This stance has reinforced market uncertainty about the ECB's policy path and further depressed European bond prices.

The ongoing escalation of the Middle East conflict is delivering an energy supply shock that is pushing government bond yields higher globally. Europe's heavy reliance on oil and gas imports makes the inflation outlook in the eurozone more complex due to volatile energy prices, putting simultaneous pressure on both bond and stock markets.

ECB "Pause" Is Not the End

The ECB kept its key interest rate unchanged at 2.25% in this meeting, but the market interprets this pause as a retention of policy flexibility rather than the end of the tightening cycle.

Madison Faller, a global investment strategist at JPMorgan, stated, "The ECB's pause today is best understood as keeping their foot hovering over the brake. Preserving optionality should not be mistaken for complacency."

In Germany, massive defense and infrastructure investment plans totaling hundreds of billions of euros are being accelerated. This large-scale bond issuance provides continuous upward support for yields.

Some analysts believe that if such spending leads to faster economic growth in Germany and its surrounding regions, it will further strengthen the case for the ECB to tighten policy.

Has the Bond Sell-Off Become Excessive?

Despite rising yields, some investors believe the adjustment in European bond markets has moved beyond what is justified by fundamentals.

Ed Hutchings, head of fixed income at Aviva Investors, said, "Value is emerging in European bonds, and increasing holdings is starting to look attractive, although some caution remains necessary in the short term."

Niall Scanlon, a portfolio manager at Mediolanum, admitted that the sharp rise in energy prices has disrupted his original strategy. "We maintained a front-end overweight based on our expectations for the ECB, and that clearly hasn't worked," he said. "Oil and gas prices have moved significantly, and we have to respect those moves."

Scanlon also pointed out that the market's pricing of the magnitude of ECB rate hikes may be overdone.

The Correlation Between Oil Prices and Interest Rates Reemerges

Bloomberg macro strategist Skylar Montgomery Koning noted that European and UK interest rates have largely reverted to a trading pattern linked to crude oil prices.

She emphasized that front-end yields have shown relative stickiness when oil prices have retreated, with price swings being less volatile than during the rally in May. However, if oil prices continue to rise, the signal from this correlation is clear: higher crude oil will once again become a common headwind for both bond and stock markets.

The US market is also not immune. Long-term US Treasury yields have remained above 5% for more than a week, the longest such stretch since 2007, with the Federal Reserve set to hold its interest rate decision meeting next week.