Euro zone bond yields surge after heavy U.S. Treasury sell-off

By Abhinav Ramnarayan and Dhara Ranasinghe

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

Ten-year U.S. Treasury yields reached their highest level in seven years on Thursday, extending a sell-off on Wednesday which helped the 10-year record its biggest one-day rise since Donald Trump was elected president, after U.S. services sector activity raced to a 21-year high in September.

U.S. Federal Reserve Chairman Jerome Powell had also talked of a "remarkably positive outlook" for the U.S. economy.

Data on Thursday showed U.S. weekly jobless claims also fell to near a 49-year low, which also helped add to expectations of strong U.S. growth.

Ten-year U.S. Treasury yields remained pinned near seven-year highs on Thursday at 3.20 percent.

Most euro zone bond yields played catch up on Thursday, rising across the board to their highest levels in months in some cases.

Italian bond yields had initially bucked this trend and fallen after the government moderated contentious spending plans, but this changed as the session wore on as a report suggested the EU was poised to reject Rome's budget plans.

Fed Chairman Powell said the central bank may raise rates above an estimated "neutral" setting.

"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 in 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 0.54 percent, still up five basis points on the day.

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

The "transatlantic spread" between United States and German 10-year bond yields hit a three decade high of around 275 bps, before receding to 267 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.

ITALIAN CAUTION

Italian borrowing costs initially fell 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.

But on Thursday morning, la Repubblica newspaper said in an unsourced report that the European Commission has already prepared a letter to open an infraction procedure against the Italian government for its plans to increase deficit spending next year.

Italian bond yields, having fallen between seven and eight basis points in early trade, were back up to trade almost flat to Wednesday's close.

Italy's 10-year yield was up two bps to 3.32 percent and the spread over Germany was 277 bps as trading wound down on Thursday.

(Reporting by Abhinav Ramnarayan; Editing by Toby Chopra, Elaine Hardcastle and Toby Davis)