Italy leads rise in euro zone bond yields as Russia cuts gas again

By Dhara Ranasinghe

LONDON (Reuters) -Italy's 10-year bond yield headed back to 4% on Monday, leading a rise in euro area borrowing costs after Russia's decision to keep its main gas pipeline to Germany shut exacerbated inflation and ECB rate-hike fears.

Russia's latest halt to gas supplies down its main pipeline to Europe, after Friday's bond market close, comes just days before the European Central Bank is expected to deliver a second big rate hike to tame record-high inflation. [nL8N30C1N4]

The European benchmark gas contract soared 30% at the open, while the euro sank to a 20-year low below 99 cents - adding to price pressures since a weak currency lifts the cost of imports.

Against this backdrop, Italian 10-year bond yields rose 10 basis points. German Bund yields also rose, having dipped in early trade.

A key market gauge of long-term euro zone inflation expectations, tracked by the ECB, rose to its highest level since mid-June at 2.2125%.

"The primary focus is the inflationary impact with the ECB increasingly focused on realised inflation rather than relying on its forecast," said ING senior rates strategist Antoine Bouvet, referring to the gas pipeline shutdown.

"This means higher bond yields and a curve flattening. Even if measures mulled by Germany and the European Union are going to ease the blow for energy consumers, I expect markets to read this as hawkish, as it would clear the way for more ECB hikes."

Italy's 10-year bond yield rose to as high as 3.98%, approaching more than two-month highs hit last week above 4%.

Germany's 10-year Bund yield was up 4 bps at 1.56%.

Euro area money markets were pricing in a roughly 90% chance of a 75 bps ECB rate hike on Thursday when the central bank meets, up from around 80% at the end of last week.

The euro was down 0.3%, having hit a new two-decade low and European stock markets were in the red.

The euro zone is almost certainly entering a recession, with surveys on Monday showing a deepening cost of living crisis and a gloomy outlook that is keeping consumers wary of spending.

Germany will spend at least 65 billion euros ($64.7 billion) on shielding customers and businesses from soaring inflation, Chancellor Olaf Scholz said on Sunday, as the standoff over Russian gas and oil exports ramped up.

Analysts said that the spending plans did not suggest bond issuance from the euro zone's benchmark issuer was about to surge.

Commerzbank rates analyst Rainer Guntermann said the spending number was bigger than anticipated.

"Yet, the bulk of this is not made up of new expenditures but rather a redistribution of inflation-driven revenues as well as measures for the next years," he said.

Elsewhere, France mandated banks for the sale of a new 20-year government bond, according to a lead manager memo seen by Reuters.

(Reporting by Dhara Ranasinghe, editing by Karin Strohecker, Angus MacSwan and David Evans)