Euro zone short-dated yields set for weekly rise as Hormuz tensions weigh on rate outlook

(Updates with afternoon trading)

By Stefano Rebaudo

April 24 (Reuters) - Euro zone short-dated government bond yields were set for their biggest weekly rise in more than a month as tensions over the Strait of Hormuz spurred energy prices higher, stoking inflation fears and European Central Bank rate hike expectations. Friday's news flow offered some support to bonds, with Iran's Foreign Minister Abbas Araqchi expected in Islamabad, venue for past peace talks with the United States, raising hope that negotiations could resume.

But the collapse of the talks earlier in the week, and the Strait of Hormuz remaining broadly closed left Brent crude futures at about $105 a barrel, well up on the week, and markets pricing at least two European Central Bank rate hikes this year, and around a 40% chance of a third.

Last week, optimism about a negotiated end to the conflict meant markets were not fully pricing two ECB rate hikes.

Germany's two-year yields, sensitive to expectations for monetary policy rates, were little changed on Friday at 2.56% but set for a weekly increase of 13 bps, their most since mid-March.

The euro zone benchmark, the 10-year German yield, was also flat on the day at 3.01%. Both had been trading higher earlier in the day, but dipped as markets saw some signs of optimism about the weekend talks, a move that extended further after U.S. Attorney Jeanine Pirro said the Justice Department is closing its investigation into cost overruns in renovations at the Federal Reserve under Chairman Jerome Powell.

The decision removes an obstacle to the confirmation of Kevin Warsh, President Donald Trump's pick to lead the central bank. The ECB meets next week, and while it is expected to keep rates on hold, it is widely expected to place a stronger emphasis on bringing inflation under control, even if doing so comes at the expense of short-term economic growth. Underscoring their dilemma, data on Friday showed German business morale fell more than expected in April, as the U.S.-Israeli war with Iran made companies more pessimistic and threatened the long-awaited recovery of Europe's biggest economy.

"The war in the Middle East and soaring energy prices have again exposed the fact that Germany is one of Europe's largest net importers of energy," said Carsten Brzeski, global head of macro at ING.

"With the war in the Middle East now gradually shifting from a pure energy price shock towards an energy supply and broader supply chain shock, the German economy is once again at the centre of an exogenous, global, disruption."

Other euro zone yields were largely moving in line with Germany's on Friday. Italy's 10-year government bond yields IT10YT=RR rose 1 basis point to 3.81%. The yield gap of Italian government bonds versus Bunds DE10IT10=RR was at 76 bps, having earlier hit 78 bps, its highest level since April 8, the day after the U.S.-Iran ceasefire announcement. (Reporting by Stefano Rebaudo; additional reporting by Alun John; Editing by Emelia Sithole-Matarise)