Euro zone yields rise as traders assess fragile Middle East truce

By Sophie Kiderlin

LONDON, April 9 (Reuters) - Euro zone government bond yields rose on Thursday, reversing some of the previous session's sharp fall, with traders weighing whether the U.S.-Iran ceasefire would hold.

Tehran has signalled there would be no deal while Israel continued to strike Lebanon, and U.S. President Donald Trump warned of a major escalation in fighting if Iran failed to reach a lasting peace deal.

There was also no sign that Iran had lifted its blockade of the Strait of Hormuz, pushing oil prices higher again on Thursday O/R.

"When you look at bond prices it's still very much oil driven," said Michiel Tukker, senior UK & euro zone rates strategist at ING, adding that markets were struggling to price the complexities of the situation, instead sticking to the "where's oil?" playbook.

Yields on the benchmark German 10-year government bond were up 8.5 basis points at 2.9866% DE10YT=RR, having fallen around 14 bps on Wednesday.

Italy's 10-year government bond yield IT10YT=RR was 9.5 bps higher at 3.80%.

INFLATION AND GROWTH CONCERNS

Government bonds have been under pressure throughout the Iran war as spiking energy prices stoke inflation concerns and shift central bank interest rate expectations. Yields have been sensitive to developments in the conflict, and tumbled Wednesday following news of the truce.

Traders also scaled back bets on future European Central Bank rate hikes, but money markets are still pricing in two policy increases from the central bank this year, with a small chance of a third. During the conflict, markets have at times priced in three ECB rate hikes this year.

The probability of a rate hike at the ECB's next meeting in April was last at around 23%.

Germany's 2-year bond yields DE2YT=RR, which are more sensitive to interest rate expectations, were 7 bps higher at 2.56%. They fell more than 23 bps on Wednesday.

ING's Tukker said economic growth concerns would play out in the belly of the curve, especially 5-year bonds, which could offer a better guide to expectations once any initial inflation spike has subsided.

"Everyone's been focused very much on the front-end of the curve, as in higher inflation expectations, more rate hikes and therefore higher 2-year rates, but what's the scenario we're looking at thereafter? Because rate hikes mean slower economic growth," he said, adding that the ECB may eventually even have to cut rates again.

Two-year yields have risen far more quickly than those on five- or 10-year debt since the start of the war. Two-year Schatz yields are nearly 55 bps higher than they were, while five-year German yields are about 45 bps higher, compared with a roughly 30-bp increase in benchmark 10-year yields.