Euro zone bond yields surge after heaviest U.S. Treasury selloff in two years

By Abhinav Ramnarayan and Dhara Ranasinghe

LONDON (Reuters) - Euro zone government bond yields rose sharply on Thursday after solid U.S. economic data sent Treasury yields to multi-year peaks and bolstered the case for interest rate hikes in the world's largest economy.

Ten-year U.S. Treasury yields on Wednesday had recorded their biggest one-day rise since the day after Donald Trump was elected president after U.S. services sector activity raced to a 21-year high in September.

Later the same day, U.S. Federal Reserve Chairman Jerome Powell hailed a "remarkably positive outlook" for the U.S. economy.

As the effects of a swelling U.S. economy are likely to send ripples through the world, most euro zone bond yields played catch up on Thursday, rising across the board to their highest levels in months in some cases.

The exception was Italy, where yields extended falls seen the previous day when leading government figures offered soothing words on the trajectory for the country's debt.

In the United States, Fed Chairman Powell said the central bank may raise rates above an estimated "neutral" setting as the "remarkably positive" U.S. economy continues to grow.

"If the Fed is to hike rates beyond the neutral level, the underlying case is that the economy is doing very well - and if the U.S. economy is doing very well, that has spillover effects the euro zone," said DZ Bank analyst Rene Albrecht.

"This will make it easier for the ECB to raise rates in 2019; and you will see this impact yields in the euro zone, especially at the long end," he added.

Germany's 10-year bond yield, the benchmark for the region, hit a 4-1/2 month high of 0.55 percent before settling at around 0.53 percent, still up six basis points on the day.

Other euro zone bond yields were up between two and five bps across the board, with French and Spanish borrowing costs hitting their highest levels in around four months.

This came as 10-year U.S. Treasury yields climbed another 5 bps on Thursday morning to a fresh seven-year peak of 3.23 percent.

The "transatlantic spread" between United States and German 10-year bond yields hit a three decade high of around 275 bps.

While this spread is not useful in absolute terms, as the debt is denominated in different currencies, many investors watch it as an indicator of diverging monetary policy stances between the two regions.

BUCKING THE TREND

With yields rising all around, Italian borrowing costs dropped on Thursday, adding to the previous day's sharp declines, after Italy said it would cut budget deficit targets from 2020 and reduce its debt over the next three years.

Prime Minister Giuseppe Conte on Wednesday confirmed a deficit target of 2.4 percent of gross domestic product (GDP) in 2019 and said this would fall to 2.1 percent in 2020 and 1.8 percent in 2021.

The estimates for 2020 and 2021 were lower than those initially reported, bringing further relief to bond markets rattled by the new government's plans to ramp up spending.

"It's a sign that the moderate forces in the coalition -- namely Conte and (Economy Minister) Tria -- are trying to calm investors' nerves and they still have something to say within the government. This is positive for Italy," said Albrecht of DZ Bank.

Italian bond yields were down as much as 7-8 basis points in early trade before pulling back as bond yields across the euro zone rose following a sharp overnight sell off in the U.S. Treasury market.

Italy's two-year bond yield was last down 2 basis points at 1.19 percent.

The gap between Italian and German 10-year bond yields, was at 281 bps, down from just over 300 bps earlier this week.

(Reporting by Abhinav Ramnarayan; Editing by Toby Chopra)