On Monday, bond markets from Tokyo to New York extended their decline, driven by rising energy prices due to the ongoing Middle East conflict. This has heightened inflation fears and prompted investors to increase bets on interest rate hikes by central banks worldwide.

The yield on the benchmark 10-year U.S. Treasury note, which moves inversely to price, surged to 4.631%, its highest level since February 2025, after climbing more than 20 basis points last week. The more rate-sensitive two-year U.S. Treasury yield reached a 14-month high of 4.102%, while the 30-year yield rose to 5.159%, a one-year high. The rise in yields bolstered the U.S. dollar and cast a shadow over equity markets, which had recently soared on an AI-driven rally.

Concurrent with the bond sell-off, oil prices also advanced on Monday, with Brent crude futures reaching $111 per barrel. This followed a drone attack on a nuclear power plant in the United Arab Emirates, which appears to have stalled efforts to end the war involving Iran. More than two months into the conflict, investors are increasingly concerned about its economic fallout and implications for the global interest rate outlook as inflationary pressures mount.

"The 'higher for longer' narrative is making a comeback, even if actual rate hikes are still not the base case scenario," said Charu Chanana, Chief Investment Strategist at Saxo Bank.

The sell-off intensified on Monday with news that the Japanese government might issue new bonds as part of a planned supplementary budget to cushion the economic impact of the war, a move that would further strain already tight public finances. The yield on 30-year Japanese Government Bonds (JGBs) jumped over 10 basis points to a record high of 4.200%, while the 10-year JGB yield touched 2.800%, its highest level since October 1996.

Eugene Leow, Senior Rates Strategist at DBS, noted that the supplementary budget news would exacerbate current anxieties in the bond market. "Market sentiment was already fragile heading into the weekend. Additional fiscal spending from Japan absolutely makes things worse," Leow said. "This feels like a sequential repricing of the yield curve in the region as investors grapple with inflation worries."

According to the CME FedWatch Tool, the market now assigns a probability of over 50% that the Federal Reserve will raise rates by December to combat rising inflation. The European Central Bank is seen potentially hiking rates as early as next month, while the Bank of England could implement around two rate hikes this year. In Europe, German Bund futures and French OAT futures fell approximately 0.4% and 0.45%, respectively.

The building inflationary pressures culminated in Monday's sharp decline, following a severe sell-off last week. That downturn was triggered by a series of hotter-than-expected inflation readings globally, particularly from the U.S., which alarmed investors.

"The key point, I think, is that we are now seeing data support the inflation fears that have been in the market since the start of the Middle East conflict," said Nick Twidale, Chief Market Analyst at ATFX Global.

Data last week showed U.S. consumer and producer prices surged in April, with similar readings emerging from Germany and Japan. While the bond rout is global, many driving factors have at least a local component. Last week, U.K. gilt yields spiked to multi-decade highs. Currently, U.K. Prime Minister Keir Starmer faces significant pressure to resign following heavy losses for the Labour Party in local elections and the emergence of challengers.