Euro zone yields drop on US-Iran peace deal optimism

(Updates pricing in European afternoon, updates latest context)

By Stefano Rebaudo

May 6 (Reuters) - Euro zone government bond yields fell sharply on Wednesday as oil prices slid and investors pared back bets on European Central Bank rate hikes amid hopes of a U.S.-Iran peace agreement.

Iran said on Wednesday it was reviewing a new U.S. proposal, after sources said Washington and Tehran were closing in on a one-page memorandum to end the war in the Gulf while leaving tricky issues such as Iran's nuclear programme for later.

Tensions around the Strait of Hormuz have fuelled inflation concerns and expectations of ECB rate hikes, lifting borrowing costs across Europe. Germany's two-year yields, more sensitive to expectations for policy rates, were last 11.6 basis points lower at 2.5664%. They reached 2.771% in late March, the highest since July 2024. Germany's 10-year yield, the euro zone benchmark, was last down 7.7 bps at 2.9937%. It touched 3.133% last week, its highest since 2011. Euro zone negotiated wage growth trends are largely unchanged since the start of the Iran war, the ECB's wage tracker showed on Wednesday. Money markets priced the ECB's deposit rate at 2.67% in December , down from around 2.70% earlier in the session. The depo rate is currently at 2%. Markets were also assigning about a 70% chance of a first rate hike next month.

Inflation trends are moving away from the ECB's baseline projection towards a more adverse scenario, raising the chance the bank may have to increase borrowing costs, board member Piero Cipollone said on Wednesday.

"The message is clear: internal divisions are widening across major central banks, and the bias is tilting toward tighter policy," said Benoit Anne, senior managing director and head of market insights at MFS Investment Management, after mentioning last week's policy meetings.

"That combination is fertile ground for further macro volatility, in our view. In this environment, an active approach to fixed income remains essential," he added. Italy's 10-year government bond yields fell 13.8 bps to 3.7465%. The yield gap between Italian government bonds and bunds was at around 72 bps. It was at 63 bps before the attack on Iran and hit 103.62 in late March, the highest since June 2025. (Reporting by Stefano Rebaudo; Additional reporting by Sophie Kiderlin. Editing by Mark Potter and Andrea Ricci )