LONDON - Investors are waking up to the worry that war in Iran may bring a lasting inflationary shock, pushing sovereign bond yields to decade highs and raising the risk of a severe hit to the spending power of governments, businesses and households.

The risk of longer-lasting inflation has ignited concern that central banks will need to quickly raise interest rates and governments may expand their borrowing to contend with any economic fallout.

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

"It feels like a bit of a perfect storm at the moment. 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," said Tom Ross, head of high yield at Janus Henderson, which oversees about $493 billion.

GOVERNMENTS' DEBT FINANCING PAIN

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G7 FINANCE LEADERS MEET IN PARIS

Benchmark 10-year U.S. Treasury yields jumped as much as 3.6 basis points to their highest since February 2025 at 4.631%, having risen nearly 17 bps in the last week, while 30-year yields, which directly impact mortgages, rose to a one-year high of 5.159%. Yields move inversely to bond prices.

Wall Street's main stock indexes were flat on Monday after pulling back sharply on Friday, with some warning that record-high U.S. stock markets have not yet priced in the risk of rocketing inflation.

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

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 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% while 10-year yields 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%, up 10 bps in a week.

Yields on bonds issued by more indebted countries like Italy and France 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 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, however, and are still the worst-performing 10-year bonds in the developed world since the war started.

(Additional reporting by Rae Wee and Ankur Banerjee in Singapore; Editing by Sam Holmes, Elisa Martinuzzi and Susan Fenton)

Copyright Reuters or USA Today Network via Reuters Connect.

This story was originally published May 18, 2026 at 10:41 AM.

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