* Yellen signals rate hikes might come sooner than expected
* Yields rise, but low-rated bonds slightly outperform
* French, Spanish bond auctions go smoothly (Updates prices, adds fresh comments)
By Emelia Sithole-Matarise and Marius Zaharia
LONDON, March 20 (Reuters) - German yields hit a two-week peak on Thursday, leading most euro zone bond yields up in a broad sell-off after the U.S. Federal Reserve signalled it could raise interest rates sooner than many had thought.
In her first news conference as the head of the U.S. central bank, Janet Yellen said the Fed would probably end its bond-buying stimulus programme this autumn and could start raising rates six months later.
The comments pushed German 10-year Bund yields , the benchmark for euro zone borrowing costs, up 6.5 basis points to 1.66 percent. Finnish, French, Dutch and Austrian yields also rose 6 bps or more.
“The Fed has provided an excuse for a selloff and it’s premised on the fact that there will be a recovery in the economy later this year and this has the potential to drive rates much higher,” said Societe Generale strategist Ciaran O‘Hagan.
Societe Generale economists, however, predict German yields will rise more modestly than U.S. benchmark yields - which jumped about 10 bps to 2.77 percent late on Wedneesday - because euro zone growth is expected to lag that of the United States. They see German 10-year yields ending the year at 2.1 percent and 10-year T-note yields at 3.55 percent.
Top-rated bonds slightly underperformed peripheral euro zone bonds, with yields on Spanish bonds up 4 bps to 3.38 percent while Italian equivalents rose 5 bps to 3.44 percent and Portuguese yields slipped.
Analysts took the move in bond markets as an indication that the Fed’s exit from the ultra-loose monetary policy which has underpinned various asset classes across the globe in recent years was unlikely to rekindle debt market tensions in the region’s weaker states. A pickup in U.S. growth would foster recovery prospects for the euro zone economy, crucial for the bloc’s weaker states to pare down their debt burdens.
It also highlighted market expectations that the European Central Bank may yet ease its monetary policy further to boost inflation - a stance that has supported appetite for high-yielding euro zone assets.
Daniel Lenz, lead market strategist for the euro zone at DZ Bank in Frankfurt, said that in an environment of rising yields across the board investors would be better off in Italy and Spain as those markets offered higher absolute returns than core markets.
Underlying the still upbeat investor sentiment in the periphery, a Spanish auction of 5 billion euros of 2017, 2019 and 2028 bonds drew better demand than previous sales, while average borrowing costs fell to pre-crisis lows for two of the bonds.
When analysts predicted at the end of last year that top-rated euro zone bond yields would rise in 2014, they cited the Fed’s gradual policy shift as the key reason. But Bund yields have actually fallen 35 bps this year, leaving many doubting a major trend reversal is imminent.
“What she (Yellen) said about the first rate hike - markets certainly didn’t expect her to be so specific,” said Jussi Hiljanen, chief fixed income strategist at SEB in Stockholm.
“But it is too early for a turnaround in the yield trend. In Europe, low inflation is a key thing and the risk - or possibility, depending on how you’re positioned - is of more action from the ECB.”
Other factors have also helped to keep Bund and other core yields low so far in 2014, notably the emerging market sell-off earlier this year and tensions between the West and Russia over the Black Sea region of Crimea.
A French bond auction earlier on Thursday went smoothly. Analysts said the rise in yields prior to the sale attracted bidders in what was also taken as a sign that investors did not foresee a major sell-off in European debt. (Editing by Ruth Pitchford)