Euro area bond yields fall with oil prices, central banks in focus

* Bond yields drop while focus shifts to central banks and oil prices pause

* Traders indicate an ECB rate hike in July and an 80% chance of a second increase in 2026

* Economists still wary of ECB tightening (Adds comments, background)

By Stefano Rebaudo

March 16 (Reuters) - Bund yields slipped on Monday but remained near their highest in almost 2-1/2 years, as the Middle East conflict stoked inflation fears and reinforced expectations of monetary tightening ahead of a busy week of central bank meetings.

Oil prices edged 0.40% higher on Monday and were up more than 40% this month as Tehran halted shipments through the Strait of Hormuz in retaliation for U.S. and Israeli air strikes.

The Federal Reserve will announce its policy decision on Wednesday, with the European Central Bank, the Bank of England and the Bank of Japan following a day later.

Central banks are expected to hold interest rates this month, but investors will focus on any clues as to how policymakers might respond to the economic impact of the conflict in the Middle East.

Yields on Germany's 10-year government bond, the euro zone benchmark, fell 2.5 basis points (bps) to 2.95%. On Friday they touched 2.994%, the highest level since October 2023.

Money markets are fully pricing one European Central Bank rate hike by July, along with an 80% chance of a second increase by year-end. The market is anticipating a proactive, zero-tolerance ECB that is willing to sacrifice growth in order to defend its inflation credibility, but most economists believe that the Governing Council will not support a near-term rate hike. "The euro area is facing a new inflation shock, but that is still likely to be temporary and modest," Berenbergchief economist Holger Schmieding said.

"It's a political bet, namely that Donald Trump has no interest in high petrol prices for American consumers for a long time and he will look for a way out," he added.

A COUPLE OF 'INSURANCE' HIKES CANNOT BE RULED OUT

Citi reiterated this morning that a couple of ECB "insurance" hikes can't be fully ruled out, even though its base case remains that uncertainty justifies the central bank inaction.

Germany's 2-year yield, more sensitive to expectations for policy rates, was flat at 2.43%, having hit 2.476% last week, the highest since August 2024.

Italy's 10-year government bond yield fell 5 bps to 3.74%. Although German bonds have lost some of their safe-haven appeal, spreads widened when war developments hurt risk appetite.

The 10-year yield spread between Italian government bonds and Bunds was at 77 bps, widening from 63 bps before the U.S. and Israel launched the war on Iran. The spread had narrowed to 53.50 in mid-January, its smallest since August 2008.

The prospect of policy rate hikes has halted the tightening of euro area yield spreads, as it could bring fiscal concerns back into focus. However, with the 5-year-5-year inflation swaps still close to 2%, there are no market signs of inflation expectations becoming unanchored, ING argued in a research note.

The market gauge of euro zone medium-term inflation expectations was at 2.2%, its highest level since March 2025.

French 10-year bonds were yielding 68 bps more than Bunds , compared with 58 bps before the conflict began.

(Editing by Kirsten Donovan and Andrew Heavens)