Euro zone bond yields shoot up to two-months highs on hawkish ECB, Fed

LONDON (Reuters) -Benchmark 10-year bond yields from Germany to France and Italy rose to their highest levels in around two months on Friday, after a Reuters report that the European Central Bank could discuss a 75 basis-point rate hike at its September meeting.

Comments from Federal Reserve Jerome Powell, speaking at the Jackson Hole central banking conference in Wyoming, added to the unease in bond markets over rapidly rising rates to contain inflation.

The U.S. economy will need tight monetary policy "for some time" before inflation is under control, a fact that means slower growth, a weaker job market and "some pain" for households and businesses, Powell said.

Some ECB policymakers want to discuss such a move at the bank's policy meeting on Sept. 8 even if recession risks loom, as the inflation outlook is deteriorating, five sources with direct knowledge of the process told Reuters in a story published shortly before Powell's speech.

The combination sent the euro higher, European shares lower and sparked another sharp sell-off in government bonds.

Two- and 10-year German government bond yields rose to their highest level in around two months, with Bund yields last 8 bps on the day at 1.40%. French and Dutch 10-year bond yields also hit two-month highs.

Italian 10-year bond yields were 16 bps higher on the day at 3.71%, having risen to as high as 3.76%.

"One new development is that the officials acknowledged (anonymously) that recession is indeed a risk, but that it won't stop the ECB from hiking," said ING senior rates strategist Antoine Bouvet, referring to the source-based ECB report.

"It is clear the ECB wants to see a bit more distance between its policy rates and the 0% line."

The ECB raised rates by 50 bps to zero in July in an unexpectedly big move.

Money markets were pricing in almost 62 bps worth of rate hikes from the ECB in September, meaning a 50 bps move is fully priced in, plus a 48% chance of a 75-basis point move, up from 56 bps, or a 24% chance of the 75 bps move, before the report.

The euro jumped after the ECB report but trimmed its gains and was last up 0.25% at around the $1 mark.

European share markets extended their fall as Wall Street sank deeper into the red following Powell's speech, with Europe's STOXX 600 index last down 1.5%.

"In short, the speech was hawkish and we would expect yields of government debt to continue to rise," said Sandra Holdsworth, head of rates UK at Aegon Asset Management.

(Reporting by Dhara Ranasinghe; additional reporting by Sam Indyk; editing by Yoruk Bahceli and Jonathan Oatis)

By Dhara Ranasinghe