Euro zone yields rise as inflation fears overshadow bonds' safe-haven appeal

By Sophie Kiderlin and Niket Nishant

LONDON, March 2 (Reuters) - Euro zone bonds headed for their sharpest selloff in nearly three months on Monday as the escalating conflict in the Middle East drove oil prices higher and rekindled inflation fears.

Germany's 10-year government bond DE10YT=RR yield, the euro zone benchmark, was 5.4 basis points higher at 2.7103%, on track for its biggest one-day gain since December. Yields move inversely to prices.

The yield on the two-year bond DE2YT=RR, which is sensitive to interest rate expectations, rose 7.2 basis points, its highest since July, to 2.0833%.

BONDS VIEWED PRIMARILY THROUGH INFLATION EXPECTATIONS

The risk-off sentiment in markets has yet to prompt a typical flight to the safety of Bunds, particularly after their strong start to the year. Bund yields in February posted their biggest monthly drop since April.

"When valuations start looking expensive, then you have to consider if you have priced in the potential risks," said Bryn Jones, head of fixed income for Rathbones.

Traders instead preferred the safe-haven appeal of the U.S. dollar on Monday, while viewing bonds primarily through the lens of inflation expectations. FRX/

A measure of euro area long-term inflation expectations EUIL5YF5Y=R jumped as high as 2.1217% from 2.0806% on Friday. It was last at 2.1067%.

"We're not in panic mode yet because investors had already started thinking of geopolitics as a persistent uncertainty," said Michiel Tukker, senior European rates strategist at ING.

RISING INFLATION WORRIES?

Oil prices surged on supply disruption concerns. Brent crude LCOc1 was last up around 8.4% to $78.52 a barrel. European natural gas futures TFMBMc1 soared 41% on the day, on track for their biggest one-day jump in four years.

OPEC+, which groups the Organization of the Petroleum Exporting Countries and allies, agreed to a modest oil output boost, as concerns of disruption to energy shipments via the Strait of Hormuz dominated sentiment in the oil markets.

A flare-up in inflation could eventually put pressure on the European Central Bank to adapt its interest rate policy. Money markets were last pricing in around an 8% chance of a rate cut by the end of the year, below a 40% chance on Friday.

The curve between the 2-year and 10-year German bond yields showed a bear flattening scenario, where shorter-dated yields rise by more than longer-dated ones. The gap between them was last at around 62.6 basis points, its lowest since November.

"The ECB's perspective really is about the more medium-term rather than the sort of knee-jerk," Andrzej Szczepaniak, senior European economist at Nomura, said, noting that the ECB was largely looking at a two- or three-year horizon, while the impact of current oil price moves would unfold before then.

Investors this week will monitor February's euro zone inflation figures, which are due on Tuesday. Data out of Germany last week showed that inflation in the euro zone's largest economy unexpectedly fell to 2% in February, pushed lower by falling energy costs.

In January, euro zone inflation fell to 1.7% after hovering around the 2% target for much of 2025.

U.S. Treasuries also sold off. The yield on the benchmark U.S. 10-year Treasury note US10YT=TWEB rose 8.4 bps. US/