December 12, 2016 / 8:53 AM / 7 months ago

UPDATE 3-Oil price surge propels euro zone yield higher

4 Min Read

* Most bond yields up 6-8 bps on oil price surge

* OPEC, non-OPEC producers agree output cut from 2017

* Investors bet on higher inflation

* U.S. 10-year yields above 2.5 pct, highest since Oct 2014

* German yield curve steepest since Sept. 2014

* Lower-rated bonds recover on Italy hopes (Updates prices, adds Italian yields)

By Dhara Ranasinghe

LONDON, Dec 12 (Reuters) - Euro zone government bond yields shot higher on Monday after a deal between OPEC and other oil producers to cut output sent oil prices surging 5 percent and put reflation trades back on the table.

There was some relief for lower-rated, southern European bonds, with Italian yields bucking the general trend and falling after a Treasury source said the government was ready to bail out ailing bank Monte dei Paschi if needed.

But for most bond markets, a rise in oil prices to 1-1/2 year peaks above $57 a barrel was the big driver, putting the emphasis back on higher inflation in a week when the U.S. Federal Reserve is tipped to raise rates for just the second time since the global financial crisis.

And with short-dated bond yields anchored by the European Central Bank's decision last week to buy more short-dated government debt for its quantitative easing stimulus scheme, longer-dated bonds bore the brunt of the selling.

France's 10-year government bond yield rose to an 11-month high at around 0.92 percent, while yields in most higher-rated euro zone countries were 6-8 basis points higher.

The yield on 30-year German bonds rose to its highest level since January, at 1.25 percent, pushing the gap over two-year bond yields to its widest since September 2014 as the yield curve steepened.

U.S. 10-year Treasury yields rose above 2.5 percent for the first time since October 2014 after the Organization of the Petroleum Exporting Countries and other producers at the weekend agreed to jointly reduce output in order to rein in oversupply and prop up markets.

"If even non-OPEC countries are joining the oil output cuts, there is a pretty good chance we get a deficit in oil supply," said Rene Arecht, a rates strategist at DZ Bank. "This is why bond markets are now pricing in a higher inflation risk."

A market gauge of euro zone inflation expectations, the five-year, five-year breakeven forward, extended its rally to a one-year high above 1.73 percent. It is up about 50 bps from a record low hit earlier this year.

In another sign of the reflation trade, breakeven rates - the gap between yields on five-year U.S. debt and a matching tenor in inflation-protected securities - was at two-month highs, indicating markets are expecting inflation to accelerate.

Southern Comfort

But in southern Europe, bond holders drew some comfort from developments in Italy that allowed borrowing costs to fall back after an early morning surge.

Italy is ready to pump capital into Monte dei Paschi if the bank fails to get the money it needs to remain in business from investors, a Treasury source said on Monday.

Its third-biggest bank is pressing ahead with a plan to raise 5 billion euros ($5.3 billion) on the market this year, despite political uncertainty after a constitutional referendum triggered a government crisis.

Italy's president on Sunday asked Paolo Gentiloni, the foreign minister in the previous government, to form a new administration

"The market has anticipated that a viable solution will be found to the banking troubles and that this won't lead to systemic problems," said Rabobank fixed income strategist Matt Cairns.

Italy's 10-year government bond yield was down 3.5 bps to 2 per cent by 1635 GMT, while Spanish equivalents were down 1 bp to 1.5 per cent at the same time. (Reporting by Dhara Ranasinghe; Editing by Janet Lawrence/Ruth Pitchford)

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