July 31 (Reuters) - Euro zone and U.S. bond yields were on

track for their biggest monthly rise since March, with

long-dated borrowing costs rising faster than those at the short

end as investors focused on the longer-term implications of the

conflict in the Middle East.

Bond yields edged lower on Friday along with oil prices

however as more supplies flowed through crucial maritime

chokepoints, despite a lack of major breakthroughs in talks

between the U.S. and Iran.

Money markets indicated a more hawkish interest rate outlook

on both sides of the Atlantic this month, fuelling a bond

selloff and pushing yields higher as the conflict in the Middle

East reignited inflation fears.

Traders returned to fully pricing a European Central Bank

depo rate at 2.75% in early 2027, a level last seen at the

height of the Iran conflict, while quickly scaling back

expectations for Federal Reserve rate cuts.

The ECB raised interest rates to 2.25% in June before

pausing this month, while the Fed has remained on hold and is

expected to deliver two rate hikes by June next year, with a

first move in October almost fully priced in by markets.

German two-year bond yields, which are particularly

sensitive to interest rate expectations, fell 0.5 basis points

to 2.76% but were still on course for a 22-bps increase in July.

U.S. two-year Treasury yields were unchanged at 4.23%

and were set for a monthly rise of 9 bps.

Long-dated bonds underperformed in July, sending their

yields sharply higher as investors began to assess the

implications of a prolonged conflict in the Middle East,

including the prospect of increased fiscal spending, larger

budget deficits and a rising debt burden.

Germany's 10-year bond yield fell 1.5 basis points to 3.15%

, but was on track for a 28-bps increase this month.

The benchmark U.S. 10-year Treasury yield

slipped 1.5 bps to 4.65% and was about to end July about 22.5

bps higher.

Elsewhere, Japan's borrowing costs were little changed with

the 10-year flat at 2.79% after the Bank of Japan

kept interest rates steady, signalling further rate hikes.