Two-year yields hit 17-month high on oil surge, Fed fears

* Fed funds futures price a 32% chance of a rate hike next week

* Five-year TIPS breakevens rose to 2.31% from 2.21% on June 24

* Treasury sees soft demand for $13 billion 20-year bonds sale

NEW YORK, July 22 (Reuters) - Interest rate sensitive two-year U.S. Treasury yields climbed to a 17-month high on Wednesday as rising oil prices stoked concerns that renewed energy disruptions stemming from the escalating conflict with Iran could reignite inflation and increase the odds of Federal Reserve interest rate hikes.

The resurgence of tensions in the Iran war has pushed inflation worries back into focus, following a brief lull after a ceasefire deal was reached in late June. Oil prices approached asix-week high as U.S. President Donald Trump vowed to destroy an Iranian bridge or power plant every time Iran shoots at a ship in the Strait of Hormuz, raising the stakes after Iranian-allied Houthis in Yemen threatened a second vital energy route. The Fed is increasingly being viewed as leaning hawkish after policymakers signalled at their June 16-17 meeting that they expect to raise borrowing costs later this year. Adding to that view, Fed Governor Christopher Waller said last week that the central bank may need to raise interest rates "in the near term" if incoming data show inflation running well above the 2% target.

“Waller had a hawkish shift in tone, with an emphasis that was totally independent of energy pass-through,” said Will Compernolle, macro strategist at FHN Financial. “That set a new anchor for a hawkish policy trajectory that had nothing to do with how the war evolved.” The 2-year note yield, which typically moves in step with Fed interest rate expectations, rose 3.68 basis points to 4.298% and reached 4.3105%, the highest since February 2025. The yield on benchmark U.S. 10-year notes rose 2.65 basis points to 4.655% and reached 4.6606%, the highest since May 20. The yield curve between 2- and 10-year notes flattened to 35 basis points. Fed funds futures traders currently see a 32% chance of a rate hike when the central bank concludes its two-day meeting on July 29, and are pricing in 76% odds of an increase by September and a 90% probability of one by year-end.

U.S. Treasury yields have also been pushed higher by rising gilt yields, driven by fiscal concerns as Andy Burnham takes over as British prime minister.

“The focus is on fiscal worries in Europe,” Compernolle said, adding that “there's just a general sell-off in global sovereign debt.”

Inflation expectations have climbed as well. Breakeven rates on 5-year Treasury Inflation-Protected Securities rose to 2.31% — implying investors expect annual inflation of 2.31% over the next five years — after dipping to 2.21% on June 24.

Real yields, which strip out expected inflation, also moved higher, with 10-year TIPS yields reaching 2.375% on Wednesday, their highest level since the "tariff tantrum" of April 2025. The Treasury Department saw soft demand for a $13 billion sale of 20-year bonds on Wednesday. The debt sold at a high yield of 5.163%, 0.4 of a basis point above where it traded ahead of the auction. Demand was below its recent average at 2.64 times the amount of debt on offer. The U.S. government will also sell $21 billion in 10-year TIPS on Thursday. (Reporting by Karen Brettell; Additional reporting by Medha Singh; Editing by Nick Zieminski and Chizu Nomiyama )

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