Euro zone yields steady, investors await possible U.S. move on Middle East

By Stefano Rebaudo and Linda Pasquini

June 19 (Reuters) - Euro zone government bond yields edged higher on Thursday as investors remained cautious amid uncertainty over potential U.S. involvement in Israeli air strikes against Iran.

Israel bombed nuclear targets in Iran on Thursday, and Iranian missiles hit an Israeli hospital overnight as the week-old air war escalated with no sign yet of an off-ramp.

Meanwhile, the Swiss and Norwegian central banks became the latest European rate-setters to ease monetary policy on Thursday, citing a weaker inflation outlook.

The Bank of England held interest rates at 4.25% as expected but stated that it was focused on risks from a weaker labour market and higher energy prices.

Germany's 10-year bond yield DE10YT=RR rose one basis point (bps) to 2.51%.

Investors are in a wait-and-see mode as a high level of uncertainty still surrounds the Middle East conflict.

Deutsche Bank argued that, in the most extreme scenario of a complete disruption to Iranian oil supply and a closure of the Strait of Hormuz, oil prices could rise above $120 per barrel.

"That would trigger a major inflation shock, reducing growth in many oil-importing countries," said Henry Allen, macro strategist at Deutsche Bank.

Oil prices LCOc1 rose almost 2% to over $78 on Thursday. They were around $65 in early June.

"Historically, oil needs to double in price to trigger a recession in advanced economies," said Raphael Olszyna-Marzys, international economist at J. Safra Sarasin Sustainable AM.

Investors are also awaiting the North Atlantic Treaty Organisation (NATO) leaders' summit next week.

It has been cut back to one session in a bid to avoid U.S. President Donald Trump walking out early as he did recently at a G7 meeting, the Financial Times reported on Thursday.

The yield on the two-year Schatz was down 0.5 bps at 1.84%. DE2YT=RR

Tariff negotiations are also in the spotlight with European officials increasingly resigned to a 10% rate on "reciprocal" tariffs being the baseline in any trade deal between the United States and the European Union.

Money markets keep pricing a European central bank deposit facility rate at 1.75% in December EURESTECBM4X5=ICAP, from the current 2%, and less than a 50% chance of a 25 bps rate cut in September. EURESTECBM2X3=ICAP

If the ECB decides to move on interest rates in the next six months, it would most likely be a cut, ECB policymaker Francois Villeroy de Galhau said on Thursday.

The U.S. central bank held rates steady as widely expected on Wednesday, with Chair Jerome Powell saying he expected to see more tariff-driven price hikes in coming months.

Italy's 10-year bond yield, the benchmark for the euro zone periphery, was 4.5 bps higher at 3.53%. IT10YT=RR

The gap between Italian and German yields widened to 101 bps, its highest since May 27.