Euro area yields rise for the third straight day before US data

By Stefano Rebaudo

Oct 4 (Reuters) - Euro area yields rose for the third straight day after dropping to multi-month lows earlier this week, while investors are bracing for U.S. data due out later in the session.

Germany's short-dated yields, which are the most sensitive to expectations about the path of European Central Bank monetary policy, bounced back after dropping to their lowest levels in almost two years.

This rebound occurred as investors became more cautious with German yields at around 2%, shifting their focus from weak figures to inflation risks related to geopolitical tensions in the Middle East.

Furthermore, the latest data showed that euro zone business activity slipped back into contraction last month although the downturn was not as steep as initially thought.

Germany's two-year yield rose 6 bps to 2.13%. It had hit 1.987% on Tuesday, its lowest level since December 2022.

Markets will closely watch U.S. data which could affect expectations for the rate outlook on both sides of the Atlantic as the Federal Reserve has shifted its focus to employment indicators after inflationary pressures eased.

"The whisper is lower (than 150,000), and we also feel it risks being lower," said Padhraic Garvey, regional head of research Americas at ING, referring to market expectations for the U.S. payrolls.

"If we were to get 150k, we'd be of the opinion that upward pressure on Treasury yields is liable to persist," he said, adding that he identified 3.9% as a target for the U.S. 10-year yield, with a possible attempt at 4%.

Markets priced in about a 95% chance of a 25 bps rate cut by the European Central Bank in October from 80% last Friday.

"The conflict may intensify with Israel's retaliation, but the safe-haven bid could remain limited and yields could rise amid talk that Iranian oil facilities could be hit," said Rainer Guntermann, rate strategist at Commerzbank.

Oil prices - one of the main drivers of consumer inflation - were subdued on Friday, but remained on track for strong weekly gains, as investors weighed the prospect of a wider Middle East conflict disrupting crude flows.

U.S. President Joe Biden said he did not believe there is going to be an "all-out war" in the Middle East, after flagging on Thursday Israel's response could include a strike on Iran's oil facilities.

Germany's 10-year bond yield, the benchmark for the euro zone bloc, rose 5 bps to 2.18%. It hit 2.011% on Tuesday, its lowest level since January.

The gap between French and German 10-year yields - a gauge of risk premium that investors demand to hold France's government bonds - was last at 78 bps. It reached its widest since 2012 beyond 85 bps during France's parliamentary elections.

The French government plans to subject its own budget to a 60 billion euro belt-tightening drive next year to help rein in a spiralling deficit.

Italy's 10-year yield rose 3 bps to 3.51% while the gap between Italian and German yields tightened slightly to 133 bps. (Reporting by Stefano Rebaudo, Editing by Hugh Lawson)