Euro zone bonds slide as Iran war drives energy prices higher

LONDON, March 5 (Reuters) - Euro zone government bonds dropped on Thursday, driving up yields, as investor concerns grew over the potential inflationary shock from the widening Middle East war.

Oil prices climbed again to near their highest levels of the now six-day U.S.-Iran war as the conflict continued to disrupt supplies. That helped put bond yields, which move inversely to prices, on track for their steepest weekly rise in a year.

German 10-year Bund yields DE10YT=RR rose 5 basis points (bps) to 2.79%. They were 14 bps higher for the week, set for the largest weekly rise since March 2025.

Two-year yields DE2YT=RR, which are particularly sensitive to shifts in inflation expectations, were up 6 bps for the day and 19 bps for the week at 2.196%.

"High energy prices have seen short-dated yields spike again today – but this is a global and not just a euro zone phenomenon," Chris Turner, head of global markets at ING, said.

ECB RATE EXPECTATIONS SHIFT

With oil and gas prices soaring, traders have rapidly priced out any prospect of the European Central Bank cutting interest rates this year, given Europe's vulnerability to energy price shocks.

Money markets showed traders are attaching a roughly 40% chance to a rate hike by July, according to LSEG data, having last week seen a chance of a cut this year.

The ECB meets on March 18-19 to decide monetary policy, and analysts expect no change to rates.

Yields on 10-year U.S. Treasuries US10YT=RR, traditionally the driver of global bond markets, rose 4 bps to 4.12% as traders also scaled back their bets on further Federal Reserve rate cuts this year.

Britain's 10-year gilt yield GB10YT=RR was also around 4 bps higher. Meanwhile, Italian IT10YT=RR and French FR10YT=RR 10-year yields were up 5 bps and 6 bps respectively.

Europe is reliant on energy imports, so the sharp rise in oil and natural gas prices has rapidly driven concerns about a renewed bout of inflation.

Brent crude oil prices LCOc1 were last up around 2% at $83.10 on Thursday, just below the 19-month high of $85.12 hit earlier this week.

Three ECB policymakers warned on Thursday that a prolonged conflict could push up inflation and weigh on growth in the euro zone.

"The baseline (is) that this is going to be short-lived," the central bank's Vice President Luis de Guindos told an event in Brussels. "If it is longer, then there is a risk that inflation expectations will change."

"I don't think we should be overly optimistic (about a swift resolution of the conflict)," Finnish governor Olli Rehn said at the same event. He noted there had already been "quite some escalation".