Euro area bond yields edge up after US attack on Iranian nuclear sites

By Stefano Rebaudo

June 23 (Reuters) - Euro zone government bonds pared earlier price losses, leaving yields steady on Monday as a retreat in oil soothed some investor concern about the inflationary impact of an escalation in the Middle East conflict.

Iran said on Monday that the U.S. strikes expanded the range of legitimate targets for its armed forces and called U.S. President Donald Trump a "gambler" for joining Israel's military campaign against the Islamic Republic.

Meanwhile, the euro zone economy flatlined for a second month in June, a survey showed on Monday.

German 10-year government bond yields DE10YT=RR, which serve as the benchmark for the wider euro zone, were roughly unchanged on the day in afternoon trading in Europe, at 2.51%, having touched a session high of 2.558% earlier.

The yield on benchmark U.S. 10-year notes US10YT=RR was up 2 bps at 4.39% in London trade.

Bunds offered little reaction to a Reuters report on Monday that Germany will raise defence spending to 3.5% of economic output by 2029, funded through a nearly 400-billion euro ($461.12 billion) borrowing programme, according to sources.

Oil proved to be a stronger driver for the bond market on Monday. Analysts said a spike in energy prices could disrupt the current narrative of more disinflationary than inflationary pressures in the euro area and the U.S., leading markets to scale back their bets on central banks' rate cuts.

"A protracted disruption of energy flows seems unlikely," said Holger Schmieding, chief economist at Berenberg, referring to oil and gas exports from the Gulf region.

The closing of the Strait of Hormuz, the crucial conduit for around 20% of global oil and gas shipments, is the key economic risk to watch.

"However, trying to throttle energy exports from the Gulf region would be a high-risk strategy for Tehran," Schmieding added, arguing that such a move would likely upset China and many other countries that do not usually side with the U.S.

Oil prices fell 1% in a volatile market on Monday after rising earlier by as much as 6% to their highest since January.

"Even limited Iranian actions, with missile strikes, mines, cyberattacks, or jamming, could meaningfully impact tanker traffic and energy flows," said Hakan Kaya, senior portfolio manager at Neuberger Berman.

Money markets priced in a European Central Bank deposit facility rate at 1.82% in December EURESTECBM4X5=ICAP from 1.78% late Friday.

A key market gauge of euro area inflation expectations EUIL5YF5Y=R rose to a fresh one-month high at 2.137%, but was still within striking distance of the ECB's 2% target.

"Our base case would be a period of uncertainty lasting a few weeks, but without a sharp escalation (of the conflict)," said Mohit Kumar, chief economist Europe at Jefferies.

"Rates market has shown a muted reaction so far, and we agree with the assessment," he argued, adding he expects yields to move modestly higher.

Investors await a NATO summit later this week which is meant to be focused on heeding Trump's call to spend 5% of GDP on defence, from the current 2% goal.

The yield on the two-year German government bond – more sensitive to expectations for ECB policy rates -- was also flat at 1.84%. DE2YT=RR

Italy's 10-year yields fell 1.6 bps to 3.51%. The premium of Italian yields over Bunds DE10IT10=RR — a market gauge of the risk premium investors demand to hold Italian debt — stood at 100.4 bps.

($1 = 0.8675 euros)