February 27, 2018 / 12:44 PM / a year ago

UPDATE 3-New Fed chief sends euro zone bond yields higher

* US, European bond yields rise after Fed chief’s comments

* Powell says economy, inflation strengthening

* Italy-Germany bond yield spread tightens

* Euro zone periphery govt bond yields tmsnrt.rs/2ii2Bqr (Recasts with market reaction to Powell)

By Dhara Ranasinghe and Fanny Potkin

LONDON, Feb 27 (Reuters) - Euro zone government bond yields rose on Wednesday after new Federal Reserve chief Jerome Powell said the U.S. economy had strengthened since December and inflation will rise, encouraging bets that the Fed might raise rates four times in 2018.

In a prepared testimony to Congress, Powell said the U.S. central bank would stick to a gradual approach to raising interest rates with inflation stuck below its 2 percent goal.

But bond markets in Europe and the United States came under selling pressure after Powell’s comments in the question-and-answer session with lawmakers.

With U.S. 10-year Treasury yields up almost 5 basis points on the day at 2.91 percent, bond yields in the euro area followed suit.

Germany’s benchmark 10-year bond yield rose 3 bps to 0.68 percent, pushing the gap with U.S. peers to around 223 bps - its widest in 14 months.

“If you’re talking about the concept of overheating, Powell is suggesting the Fed will err on the side of caution,” said Chris Scicluna, head of economic research at Daiwa Capital Markets.

Scicluna cautioned against reading too much into one set of remarks from Powell but added: “You can say the risk is on the side of higher rates.”

U.S. short-term interest rate futures fell after Powell’s comments. Traders continued to expect the first hike of the year to come next month, and see a more than one in four chance that the Fed would raise rates three more times this year.

Most euro zone bond yields were up 2-3 bps on the day, although Italian bonds outperformed after strong demand at a debt auction, the last one before this weekend’s national election.

The southern European country, which goes to the polls on Sunday, sold around 7.71 billion euros of debt.

That was towards the top end of a targeted range, suggesting sentiment towards Italy remains firm ahead of the election.

“Given the risks we have ahead of the election and with bond yields turning up, the auction results saw fair demand,” said Daniel Lenz, a rates strategist at DZ Bank.

Italy’s 10-year bond yield fell 2 basis points to 2.09 percent. The gap between Italian and German bonds yields moved to 143 bps, its narrowest in five days and well below recent highs of 152 bps.

The spread had widened in recent weeks as the election approached, making Italian bonds more attractive to those investors who take a more sanguine view of political risk in the euro zone’s third-largest economy.

Additional reporting by Fanny Potkin and Abhinav Ramnarayan Editing by Susan Fenton

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