July 20 (Reuters) - U.S. Treasury bond yields ticked higher

on Monday, but were still headed for their sharpest week-on-week

decline this month after softer-than-expected inflation readings

last week prompted investors to scale back their bets on an

imminent rate hike.

The 2-year yield, which tracks near-term Federal

Reserve policy expectations most closely, traded near 4.183%,

slightly below its highest level since February 2025. The yield

has fallen nearly 8 bps since last Monday, making this its

largest week-on-week drop since June 29.

The yield on the benchmark U.S. 10-year Treasury note

edged up 1 basis point to 4.558%, about 8 bps off

its July 14 high, as prices have risen.

Money markets currently expect the Fed to hold rates at

3.50%-3.75% at its July 28-29 meeting. Prior to data last week

showing consumer and producer prices increased

less-than-expected in June, traders saw a 40% chance of an

interest rate hike.

For the rest of the year, traders have fully priced in one

25-basis-point hike from the Fed and see roughly a one-in-three

chance of a second quarter-point increase.

Inflation expectations have been dropping almost uninterruptedly

this month. A market-based measure of inflation in a year's time

fell below the Fed's target rate of 2% for the

first time since October 2024 last week - just as the oil price

was breaking above $85 a barrel.

"It remains difficult to fully price out further Fed

action, given still-elevated inflation, AI-driven demand

pressures, and persistent hawkish rhetoric from Fed Chair

Warsh," Barclays strategists said in a note.

"The risks seem to be toward pricing a prolonged

expansionary cycle with stubborn inflation, whereby the Fed

delivers more than calibration/credibility hikes, or a

higher-for-longer world in which the Fed stays put

indefinitely."

Oil prices crept back higher as prospects of a sustainable peace

deal between U.S. and Iran receded. U.S. forces hit Iran for a

ninth consecutive day on Monday, sparking worries about shipping

supply through the Strait of Hormuz.

The U.S. economic docket is light this week and the Fed

remains in a blackout period before its policy meeting next

week.

U.S. 2-year Treasuries have outperformed the rest of the G7

complex by a wide margin, as investors price in a lower chance

of the Fed raising interest rates, compared to a greater

probability that other major central banks in energy-importing

nations may be forced to do so.

In the last week, 2-year yields have fallen by over 8 basis

points, compared with a rise of almost 8 bps in Italian 2-year

yields, or a 5.5-bp rise in German yields.