By David Finnerty and James Hirai

(Bloomberg) -- Short-end Treasuries headed for a fourth day of declines on Friday as oil prices above $100 a barrel reinforced fears of an inflation surge.

US two-year yields, which are among the most sensitive to monetary policy, climbed nine basis points to 3.88%. Money markets are betting the Federal Reserve will hold interest rates steady this year, marking a sharp turnaround from before the start of the Iran war when two quarter-point cuts were cemented in.

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“The inflation backdrop is growing increasingly problematic for the Fed and rate cuts are not likely anytime soon,” James Reilly, senior markets economist at Capital Economics, wrote in a note.    

The Fed, European Central Bank and the Bank of England all held rates this week as policymakers grapple with the uncertain outlook for inflation and growth arising from the conflict in the Middle East. But officials are signaling to markets that they are ready to act soon if necessary to contain inflationary pressures.

The ECB will need to consider hiking interest rates as soon as next month if price pressures build further due to the Iran war, Governing Council member Joachim Nagel said on Friday. That followed BOE Governor Andrew Bailey warning Thursday that policy “must respond” to the risk of a more persistent impact of the energy shock on prices.

Still, while bets on Fed rate cuts this year may have vanished, the chances of easing next year have increased, with swaps implying at least one quarter-point reduction by the end of 2027.

“A short-lived oil shock could potentially open up space for a cut in the fourth quarter under the next chair, while a more severe shock — especially one that tightened financial conditions — could actually lead to more rate cuts if accompanied by a weaker labor market,” said Idanna Appio, portfolio manager and senior research analyst at First Eagle Investments.

--With assistance from Malavika Kaur Makol.

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