Euro zone bonds mixed amid Iran deal hopes, UK vote also in focus

By Amanda Cooper and Stefano Rebaudo

LONDON, May 7 (Reuters) - Euro zone government bonds were mixed on Thursday after staging their biggest rally in a month the previous day, as investors grew optimistic that the U.S. and Iran might soon reach a deal to end the war.

Brent oil prices LCOc1, which have been a driving force for broader financial markets since the war broke out in late February, were last down modestly below $100 a barrel on Thursday, having slid more than 10% the previous day on the back of the prospect of a U.S.-Iran peace deal.

With some concern about a damaging energy-price shock abating, bonds held on to most of the gains made on Wednesday, when two-year yields, which are most sensitive to expectations for inflation and interest rates, dropped sharply.

Two-year Schatz yields DE2YT=RR fell nearly 12 basis points on Wednesday, the most since April 8, and were last at 2.56%, roughly unchanged on the day.

The United States and Iran are edging toward a limited, temporary agreement, sources and officials said on Thursday, with a draft framework that would stop the fighting but leave the most contentious issues unresolved.

Two-year Italian yields IT2YT=RR, some of the worst-affected by concerns about inflation, were last down 0.5 basis points at 2.74%, having dropped 13 bps the previous day. Italian two-year bonds have been the second-worst-performing major economy bonds during the war, having risen 60 bps, behind British two-year yields, which are up 85 bps.

Commerzbank analysts said euro zone bond markets remained in "bull steepening mode" - a dynamic where shorter-dated yields are falling more quickly than those on longer-dated bonds, as investors attach a lower chance to imminent rate hikes.

So far this week, two-year Schatz yields have fallen 7.1 bps, compared with a 4.6-bp drop in benchmark 10-year Bund yields DE10YT=RR and just 1.3 bps for 30-year yields DE30YT=RR. The pattern is similar in other markets, such as Italy and France 0#FRBMK=.

Money markets show traders are attaching roughly a 75% chance of a June hike from the European Central Bank, down from about 88% at the end of last week.

UK VOTE IN FOCUS

Markets are awaiting the outcome of the UK local elections, which could cast doubt on Prime Minister Keir Starmer’s future and potentially revive concerns about fiscal slippage.

"If voters deliver heavy losses to Labour today by switching to the far-left Greens or right-wing Reform, the key risk is that the party concludes ‘enough is enough’ and moves against Starmer," Kallum Pickering, chief economist and deputy head of research at Peel Hunt, said.

"If that occurs, the danger of a sharp leftward lurch by the government looms large."

However, much of the negative news appears priced into gilts, with 10-year yields already having surged above 5% earlier this week. They were last at around 4.94%, little changed on the day, after reaching 5.107% on Monday and 5.118% in late March - their highest levels in roughly 18 years.

($1 = 0.8512 euros)