Global bond markets experienced a sharp sell-off after major central banks expressed concerns that surging oil prices could trigger a new wave of inflation. As the war in Iran upends the global economic outlook, markets are undergoing a significant repricing.

Short-term bonds led the declines, with investors betting that European central banks will be forced to raise interest rates, while the Federal Reserve is expected to hold rates steady for the remainder of the year.

This pushed the yield on the two-year US Treasury note up by 18 basis points to 3.95% during early Thursday trading, before paring gains to approximately 4 basis points.

European markets saw steeper losses, with energy price jumps due to Middle Eastern supply disruptions expected to heavily impact the European economy. New policy guidance from the Bank of England led traders to price in three 25-basis-point rate hikes this year, causing the two-year UK gilt yield to surge over 28 basis points to 4.38%. The yield on German bonds of the same maturity rose by 8 basis points.

"The previous consensus was that this would end relatively quickly," said Brij Khurana, a portfolio manager at Wellington Management. "Now the market is finally beginning to fear that the war could last much longer."

The market downturn highlights the dramatic shift in the global economic outlook since the US launched military action against Iran late last month. Less than three weeks ago, traders were anticipating two Fed rate cuts this year, and the Bank of England was expected to cut rates at its recent meeting to support a weak labor market.

However, the Middle East conflict and its disruption to global energy and trade have shattered those expectations, with no signs of a quick resolution to the hostilities. On Thursday, oil and natural gas prices climbed further as escalating attacks in the Persian Gulf posed long-term threats to major energy infrastructure.

Comments from central bank officials this week indicated that, despite the threat of slowing economic growth from soaring oil prices, their primary focus remains on upside inflation risks.

Although the European Central Bank held rates steady for the sixth consecutive meeting, traders still expect at least two rate hikes this year to curb inflation, even as ECB President Christine Lagarde emphasized the war's downside risks to economic growth.

"Central banks are beginning to adjust their policy guidance in response to rising inflation prospects," noted Thierry Wizman, global foreign exchange and rates strategist at Macquarie Group. "So far, they are leaning towards worrying more about the inflationary consequences of an energy shock than about potential impacts on unemployment."

Federal Reserve Chair Jerome Powell stated on Wednesday that the Fed needs to see further progress in taming inflation before considering interest rate cuts.

However, the possibility that the Fed might intervene if the economy stagnates may have limited the extent of the sell-off in US bond markets. Futures market pricing suggests slightly more than a one-in-three chance of a rate cut this year.

"The Fed's dual mandate sets it apart from other central banks," said Gargi Chaudhuri, Chief Investment and Portfolio Strategist for the Americas at BlackRock, in an interview. She believes the Fed is "more likely to focus on a growth shock and ease policy rates. This is a central bank that is more inclined to adopt accommodative policies if economic growth is impacted."