By Min Zeng

A deepening rift between the U.S. and Mexico sent some investors into the harbor of U.S. government bonds on Thursday, pushing the yield on the 10-year note lower from a one-month high.

Bond prices rose for the first time in three days, also boosted by solid demand from a $28 billion sale of seven-year notes. A gauge of foreign demand reached the highest on record.

The yield on the benchmark 10-year Treasury note settled at 2.508%, compared with 2.523% Wednesday. Yields fall as bond prices rise.

The yield earlier had risen to a one-month high of 2.553%, as the reflation trade driven by the prospect of expansive fiscal stimulus from President Donald Trump regained some momentum.Buyers returned after Mexican President Enrique Peña Nieto canceled a visit to the U.S. next week amid pressure from Mr. Trump to pay for a border wall, in the biggest diplomatic rift between the neighbors since the North American Free Trade Agreement was implemented in 1994.

The news highlights the challenges investors confront to bet on the outcome from Mr. Trump's policy mix.

His proposals of fiscal stimulus have boosted expectations toward stronger economic growth and higher inflation, denting investors' appetite for government bonds and putting upward pressure on Treasury bond yields. On Thursday, Mr. Trump reiterated his intent to lower taxes and roll back financial regulations, seen by investors and economists as pro-growth measures.

Yet investors are concerned that Mr. Trump's protectionist stance could generate trade frictions and undercut the growth momentum in both the U.S. and its trading partners. Thursday's rebound in bond prices again reflects this angst.

"The U.S. President's executive orders helped to launch risk-on optimism" that hurt the bond market during the previous two days, but "confrontational positions can stanch the optimism as well," said Jim Vogel, an interest-rate strategist with FTN Financial.

The news from Mexico Thursday bolstered demand for the seven-year auction. One highlight of the auction was 72.8% indirect bidding. A proxy of foreign demand, it surpassed the previous record of 72.7% in November.

U.S. Treasury bonds offer much more appealing yields compared with their peers in Europe and Japan, drawing foreign buyers seeking relative value in a still very low yield world.

The uncertainty about Mr. Trump's policy impact on the broader economy is going to take time to play out, and analysts say this is likely to fuel more bond price fluctuations in the near term.

The 10-year yield reached a two-year high of 2.6% in mid December from 1.867% traded on Nov 8, the U.S. Election Day. It pulled back and fell to near 2.3% last week. But its ascent renewed this week amid record-setting stock prices. The Dow Jones Industrial Average rose above 20000 Wednesday for the first time ever, a sign of optimism toward the U.S. economy.

A number of economic releases have painted a brighter outlook for the U.S. economy at a time when the labor market is approaching full employment and some inflation readings have reached the Fed's 2% target.

Data outside the U.S. also show some improvement in Japan and Europe while the risk of a sharp slowdown in China has diminished.

One big threat to the bond market is a further rise in inflation, which chips away bonds' fixed returns over time.

Prices of commodities, such as crude oil, have rebounded after a big decline between late 2014 through early 2016. This has pushed up inflation expectations.

The 10-year break-even rate, the yield premium investors demanded to hold the benchmark 10-year Treasury note relative to the 10-year Treasury inflation protected security, was 2.08 percentage point Thursday. It was the highest since September 2014 and reflects investors' expectation of an annual 2.08% inflation rate over the next 10 years.

"Both domestic and global inflation expectations continue to tick up and the data over the past four months has exceeded expectations," said Michael Lorizio, senior trader at Manulife Asset Management. "The market seems to have regained focus on these economic fundamentals."

Analysts say yields have room to rise as they are still at very low levels from a historical standpoint. Some say the 10-year Treasury yield could rise to 3% -- a level it traded in early 2014 -- before the end of this year.

Write to Min Zeng at min.zeng@wsj.com

(END) Dow Jones Newswires

January 26, 2017 16:03 ET (21:03 GMT)

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