Traders temper euro zone rate hike bets as ECB grapples with Iran war impact

(Updates with further comment and context)

* Markets slightly trim 2026 ECB rate hike bets

* ECB leaves rates unchanged, flags trade-offs

* Rate-sensitive bond yields fall as oil drops

By Harry Robertson and Amanda Cooper

LONDON, April 30 (Reuters) - Traders on Thursday slightly tempered their bets that the European Central Bank will hike interest rates three times this year, after policymakers flagged the trade-off between rising inflation and the hit to growth from higher energy prices. The ECB held rates at 2%, with President Christine Lagarde saying officials were conscious of the risks to the economy from the war but had also debated a hike at length.

Two sources close to the discussion later told Reuters the ECB is likely to raise interest rates at least twice, starting in June. Government bond yields across the bloc dipped after the decision as traders trimmed their wagers on rate hikes this year. Money markets now price in a roughly 88% chance of a quarter-point hike in June, having fully priced in such a move earlier on Thursday.

They expected around 72 basis points of hikes by year-end, indicating they were no longer certain the ECB would execute three 25-bp increases this year.

"Clearly they (ECB policymakers) want to keep their options open so that they can remain data dependent and have time until the next meeting to see how inflation develops," said Jill Hirzel, senior investment specialist at Insight Investment.

"They've got just the inflation mandate, but they consider the impact on growth as well," Hirzel said, adding that she leans towards expecting two rate hikes this year.

Two-year German bond yields, sensitive to ECB rate expectations, were last down 7 bps at 2.65%.

A fall in oil prices from a four-year high helped drag yields lower - as did data from earlier in the session showing that the euro zone economy barely grew in the first quarter.

The tepid growth underscores how vulnerable Europe, a major importer of oil and gas, is to rising energy prices and the tricky situation facing the ECB.

Germany's IMK institute sees a 34% chance the bloc's largest economy slips into recession in the second quarter, up from 12% in March.

MARKETS VOLATILE AS WAR CLOUDS OUTLOOK

Markets are grappling with a fast-moving situation and expectations have swung wildly.

Two weeks ago, oil prices were down significantly in the wake of the April 8 ceasefire and traders sharply reduced ECB rate-hike bets, only for them to ramp up again over the last week.

Just on Thursday, benchmark Brent crude oil prices rose to their highest since 2022 at $126.41 before falling sharply to $114.

"It's difficult for central bankers," said Joost van Leenders, senior investment strategist at Van Lanschot Kempen, adding that he thinks pricing of three hikes from the ECB this year "is a bit aggressive".

The Bank of England on Thursday held rates at 3.75% but British bond yields fell as traders also detected a slight reticence to raise rates. The U.S. Federal Reserve kept rates steady on Wednesday.

"These central banks are buying time to understand how long the conflict goes on (and) the oil price remains persistently high, and possibly gathering information at any level on possible second-round effects," said Alessia Berardi, head of global macroeconomics at the Amundi Investment Institute.

The euro fell very slightly after the ECB's decision, but then climbed to trade 0.5% higher at $1.173. European stocks extended their gains and rallied 1.3%.

Pictet Asset Management lead economist Nikolay Markov said his firm expects the ECB to raise rates twice this year.

Yet he also said that a longer-than-expected closure of the key Strait of Hormuz and a sustained rise in oil to $150 a barrel could push euro zone inflation to 6%, double its rate in April.

(Reporting by Harry Robertson; Editing by Amanda Cooper, Dhara Ranasinghe and Toby Chopra)