Euro zone yields steady near multi-year highs as investors catch their breath

By Alun John

LONDON, May 19 (Reuters) - Euro zone bonds steadied on Tuesday, with yields just shy of multi-year highs hit the previous day when investors braced for a sustained period of high energy prices that could spill over into broader inflation and cause central bank rate hikes. Helping the mood on Tuesday was a social media post from U.S. President Donald Trump saying he had paused a planned attack against Iran after Tehran sent a peace proposal to Washington, and that there was now a "very good chance" of reaching a deal limiting Iran's nuclear program.

That sent Brent crude down 1.8% to $110 a barrel, and also supported bonds. Germany's 10-year yield, the benchmark for the euro zone, was down 1 basis point at 3.14%.

It rose as high as 3.19% on Monday, its highest since 2011, and has risen dramatically from below 2.70% before the Iran war began.

Global bond markets have been broadly moving in line with each other, as central banks around the world all keep a wary eye on energy costs and their impact on inflation.

On Tuesday, the 10-year Treasury yield was down nearly 2 bps at 4.61% after hitting a one-year high on Monday of 4.31%. Elsewhere in Europe, Italy's 10-year yield was also down 2 bps at 3.92%.

However, analysts at UBS said in a note they thought "the market may be underestimating cross-country differences in economic impact and central bank reaction functions."

They argue the fact the euro area is facing a larger economic hit from the war should limit the amount of European Central Bank rate increases, and so support euro zone bonds.

UBS analysts see the gap between U.S. and German 10-year yields widening to 150 bps from its current 144 bps.

Markets currently see around an 80% chance of a 25 basis point ECB rate hike next month and see two further such moves as likely by year end.

They are not fully pricing any Fed hikes this year, though last week's hot inflation data left traders seeing around a 60% chance of one 25 bp hike by the end of the year, and markets have long priced out earlier expectations of rate cuts.

British government bonds outperformed on Tuesday with their 10-year yield down around 4 bps at 5.08% after data showed Britain's employers reduced hiring and posted fewer job vacancies in April, prompting investors to cut their bets on Bank of England interest rate hikes.

Shorter-dated yields in the euro zone were also roughly aligned with longer-dated ones on Tuesday. Germany's two-year yield dropped 1 bp to 2.71%.

(Reporting by Alun John, editing by Gus Trompiz and Tomasz Janowski)