Euro zone bonds head for worst month in years as war stokes inflation fears

By Amanda Cooper

LONDON, March 27 (Reuters) - Euro zone government bonds edged up on Friday, with short-dated debt heading for its worst monthly performance in years, as the Iran war has sent energy prices soaring and wreaked havoc with interest rate expectations, prompting an investor push out of fixed income assets.

U.S. President Donald Trump on Thursday extended into April his deadline for Iran to reopen the Strait of Hormuz - through which a fifth of the world's energy supplies pass - or face strikes on its power infrastructure.

This initially knocked the crude price sharply lower LCOc1 and helped push Treasury yields down. But by Friday, a realisation had set in among investors that the delay likely means a longer war, raising the risk of a sustained increase in inflation, which hurts bonds.

ITALY'S BONDS HIT HARDEST

Two-year Italian bonds IT2YT=RR have been among the hardest hit since the start of the war, given the country's dependence on energy imports and its more vulnerable public finances. Yields have risen by nearly a percentage point, ranking them second only to two-year UK gilts in terms of underperformance in the last month.

March's 92-basis-point rise would be the largest monthly increase in two-year Italian yields since May 2018, when they rose by 130 bps.

German two-year yields DE2YT=RR have not fared much better, having risen 72 bps this month, the most since August 2022. The gap between two-year German and Italian yields is now around its widest in almost a year, at 96 bps.

By Friday, German 10-year Bund yields DE10YT=RR, which serve as a benchmark for the wider euro zone market, were up 2 bps at 3.082% and set to end March 40 bps higher, at their highest since 2011.

"The good news this morning is that the escalation risks over the weekend have subsided with Trump extending his ultimatum from Saturday to 6 April," Commerzbank strategist Christoph Rieger said.

"However, the muted market reaction in Asia underscores that a deal over the next 10 days has not become more likely with Trump just seen buying time to deploy more troops," he added.

Rates markets have logged one of their most dramatic turnarounds on record in March. Expectations for European Central Bank monetary policy have flipped to show traders think the central bank could raise rates at least twice, with a good chance of a third increase, by year-end, from having previously priced in a roughly 40% chance of a cut in 2026.

Adding to the pressure has been poor demand for government debt in the past few weeks. Treasury and Bund auctions have drawn far fewer bids than sales in previous months. The last 10-year Bund auction on March 11 drew the poorest demand since October, which in turn was the worst in several years.