Euro zone bond yields inch higher; Iran optimism wears thin

Updates pricing in European afternoon

By Amanda Cooper

LONDON, Aug 6 (Reuters) - Euro zone government bond yields edged up on Thursday as markets watched out for signals of a possible re-opening of the Strait of Hormuz, as energy prices remain well above pre-war levels and any deal on maritime traffic may prove fleeting, analysts said.

Oil prices were last just above $81 a barrel LCOc1 as investors were cautious about the outcome of Iran-Oman talks. A proposed deal between the two to help end the U.S.-Iran conflict would give Tehran control over ships entering the Gulf through the Strait of Hormuz. Lower energy prices limit the risk of a damaging spike in inflation, which hurts bonds.

German 10-year yields DE10YT=RR traded at 3.12% on Thursday, up 1.7 basis points, while 2-year yields DE2YT=RR rose 1.6 bps to 2.73%.

Crude futures are around 12% above where they were before the war broke out in late February, while European physical crude prices are still anywhere between 18% and 25% above those levels, which could curtail further rallies in bond prices, analysts said.

"A deal could see 10-year U.S. Treasuries moving back towards 4.5% and 10-year Bunds towards 3%, but we do not see a rally much beyond that. Our base case remains that oil would likely settle in the $75-$80 range, which is still a good 25%-30% higher than pre-war levels and would need to be factored into growth and inflation expectations," Jefferies strategist Mohit Kumar said.

On the supply front, France sold nearly €8 billion ($9.2 billion) in 10-year bonds on Thursday and, although demand held up well, the cost of borrowing spiked.

Unease over European governments' long-term financing, combined with volatile domestic politics, has undermined French bonds recently. OATs FR10YT=RR have been the poorest performers among the G7 debt markets in the last month.

At 2.909% on Thursday, 2-year OATs are yielding roughly 20 bps more than a month ago, compared with top-performing 2-year U.S. Treasuries, with a rise of around 9 bps, and a whisker ahead of the rise in German Schatz yields in that time.

Benchmark 10-year yields are nearly 18 bps higher than a month ago, compared with roughly 11 bps for UK gilts, the best-performing bonds in the last month GB10YT=RR.

France sold May 2036 paper at an average yield of 3.737% on Thursday, up from 3.68% at the July auction, as well as November 2036 bonds that achieved an average yield of 3.9%, up from 3.73% last month.

French 10-year OATs FR10YT=RR were trading 1.9 bps higher on the day at 3.91%.

Spain also sold nearly €2 billion in 10-year debt on Thursday, for an average yield of 3.542%, up from an average of 3.395% at the last such sale in July, as well as €1.85 billion in 5-year debt for an average 3.005%, up from 2.835% in July. Yields on the benchmark 10-year Bono ES10YT=RR were up 1.4 bps on the day at 3.56%.

($1 = 0.8666 euros)

(Reporting by Amanda Cooper, additional reporting by Sophie Kiderlin. Editing by Tomasz Janowski and David Holmes)