European bonds head for worst weekly selloff since March as energy prices soar

Adds comment, refreshes prices

By Amanda Cooper

LONDON, Sept 11 (Reuters) - Euro zone government bond prices recovered modestly on Friday, as the global debt market headed for its worst weekly performance since the start of the Iran war, battered by surging energy prices that are forcing central banks to act quickly to combat inflation.

The European Central Bank on Thursday increased euro zone rates by a quarter point, as expected, while raising its forecast for inflation and cutting its growth projection.

U.S. consumer inflation data later on Friday could boost expectations the Federal Reserve will raise rates when it meets next week. The Bank of Japan meets next week as well and is also widely expected to lift borrowing costs.

Bond yields across the Group of 7 biggest economies have risen by the most so far this week since the start of the war in late February. Two-year yields are being hit particularly hard, as investors have rushed to price in a growing chance that policymakers from Tokyo to Washington and Ottawa will lift borrowing costs to ward off a damaging spike in inflation.

Attacks by U.S. and Iranian forces on targets, including tankers, around the Gulf have fanned fears of the conflict widening across the Middle East, while energy shipments through the Strait of Hormuz have slowed to a handful and producers like Saudi Arabia are starting to cut production.

German 2-year bond yields DE2YT=RR fell 2 basis points on Friday to 3.16%, having traded around 3 bps higher earlier in the day. They have risen nearly 23 bps this week, the most since the first week of the war in early March.

Two-year yields on G7 debt have risen by 20 bps this week on average, the most since that same week, while 10-year G7 yields have risen nearly 18 bps, led by a 24-bp increase in French yields. U.S. 10-year Treasury yields, meanwhile, are about to touch 5% for the first time since October 2023, a high previously hit in 2007.

"The week is ending on a chaotic, confusing and very uncertain note, with escalating tensions in the Red Sea seemingly tipping the balance for oil prices, and inflation risks, as the conflicts in the Persian Gulf and Black Sea show no sign of easing," Marc Ostwald, chief economist and global strategist at ADM Investor Services, said.

"The spillover into interest rate markets is becoming more acute."

Short-dated bonds have been hit hard this week, but policymakers and investors are keenly watching long-dated yields, which reflect investor confidence in governments' long-term finances.

"We have stayed away from duration since July. We are still not inclined to buy the long end of the curve. However, rates could get a short-term respite if the CPI data today is on the benign side," Jefferies strategist Mohit Kumar said.

Benchmark 10-year Bund yields DE10YT=RR, which have risen nearly 17 bps this week, were last up 1 bp on the day at 3.502%.

ECB President Christine Lagarde said Thursday's rate hike was a "no-brainer", and warned that the return of inflation to its 2% target, now seen at the end of 2027, could be delayed even further.

Money markets show traders think the ECB will raise rates three more times by next March, with a fourth hike by June.

Euro zone yields rose broadly, with Italian 10-year debt yielding 4.383%, up 1 bp.

Two-year Italian bonds IT2YT=RR, which have been the worst performers among the G7 this week, with a rise of 26.4 bps, jumped in price, which sent yields down 5 bps to 3.387%.

French bonds gained some respite, temporarily shrugging off an increasingly complex fiscal picture, leaving 2-year yields FR2YT=RR down 1 bp at 3.374%, up nearly 25 bps this week, the most since mid-May.

Finance Minister Roland Lescure said on Friday that France's economy will grow less than expected this year and the government will miss its budget deficit target.

(Reporting by Amanda Cooper; Editing by Joe Bavier)