Italian yield hits 4% as ECB rate hike bets batter bonds

LONDON (Reuters) - Euro zone bond yields rose sharply on Thursday and the Italian 10-year yield briefly breached 4% for the first time since June as traders jacked up their bets on a big European Central Bank interest rate hike next week.

Euro zone money markets on Thursday were pricing in a roughly 85% chance for a 75 basis point rate hike, following Wednesday's record-high inflation print. That is up from a slightly more than 50% chance that was priced in on Wednesday before the inflation numbers.

The rise in rate expectations sent government bond yields sharply higher across the bloc, especially at longer 10-year plus maturities.

"The long-end is catching up with the prospect of higher rates and inflation that is set to run for longer than many were thinking," said Rene Albrecht, a strategist at DZ Bank, noting much smaller moves in short-dated yields where he said the likelihood of a bigger 75 bps ECB rate hike was priced in.

He expects the ECB to hike by 50 basis points next week, with some policymakers concerned about the rising gap between Italian and German bond yields.

Italy's 10-year bond yield jumped as much as 13 basis points to its highest since mid-June at 4.014%. Italian yields hit as high as 4.28% in June, prompting the ECB to promise a new instrument to prevent an excessive divergence in government borrowing costs within the 19-country currency bloc.

The rise on Thursday pushed the closely watched gap between German and Italian bond yields to 243 basis points - its widest since late July - before it retreated.

Italian two- and 30-year yields briefly rose 10 basis points in early trading.

"This week's European inflation data has shown that price pressures continue to be strong in the euro zone," Mizuho analysts said.

"The ECB's 8th September meeting is still a close call, but this latest data will likely be enough to tip even the centrist members towards a 75 basis point hike," they added.

The data released on Wednesday showed euro zone inflation rose to another record high at 9.1% in August, beating expectations and solidifying the case for further big ECB hikes.

Germany's 10-year yield shot up 10 basis points to 1.634% but then edged down and was last up 3.5 basis points at 1.57%. Ten-year yields in other countries rose 3 to 4 basis points .

German yields ended August with their biggest monthly surge in over 30 years.

Bond markets across Europe have been battered as surging gas prices, fueled by Russian supply concerns, fanned inflation worries and pushed up expectations for higher rates even as recession fears mount.

(Reporting by Tommy Reggiori Wilkes; Editing by Simon Cameron-Moore, Bernadette Baum and Richard Chang)