Euro zone yields rise on fear that US-Iran war will drag on

By Alun John

LONDON, May 11 (Reuters) - Euro zone yields rose on Monday after U.S. President Donald Trump swiftly rejected Iran's response to a U.S. peace proposal, driving up oil prices and bolstering expectations that inflation will force the European Central Bank to tighten policy.

Germany's rate-sensitive 2-year government bond yield rose nearly 6 basis points to 2.65%, with markets close to fully pricing in an ECB rate hike at its June meeting.

Markets fully price two 25-basis point hikes across the ECB's three meetings to September and see around a 75% chance of a third by year-end.

Germany's 10-year yield, the euro zone benchmark, rose 4 bps to 3.04%.

Yields have tracked oil prices. Benchmark Brent crude June futures were up 2% at $103.5 a barrel, below late April highs but well above pre-war levels, with only limited shipping passing through the Strait of Hormuz.

Bond markets are watching closely.

"European rates are likely to stay directional with geopolitics in coming weeks," Goldman Sachs analysts said in a note.

ECB policymakers have warned they are ready to act if high energy prices spill over into broader inflation.

Governing Council member Martin Kocher said in an interview published on Monday that "if the situation does not improve significantly, there will be no avoiding an interest rate move in the near future".

"What's clear is that if the war drags on and energy prices remain high, the risk of second-round effects will increase," said Kocher, Austria's central bank governor.

Goldman Sachs analysts said they saw limited risk of substantial second-round effects, citing a stable ECB wage tracker, the growth hit from high energy costs and the central bank's hawkish messaging.

Other euro zone yields moved broadly in line with Germany's. Italy's 10-year yield was up 6 bps at 3.80%.

That left the spread to Germany at 71 bps, near the middle of its recent range.

Investors kept a wary eye on Britain, where speculation about a leadership challenge to Prime Minister Keir Starmer is building.

Britain's 10-year yield was last up 9 bps at 5.01%. (Reporting by Alun John. Editing by John Mair, Mark Potter and Alex Richardson)