(Updates after gilt sell-off)

By Samuel Indyk

LONDON, July 2 (Reuters) - Euro zone government bond

yields rose on Wednesday, taking their cues from Britain's gilts

where yields spiked higher after the government scaled back

plans to cut benefits, reigniting worries about global fiscal

sustainability.

British bonds suffered a steep sell-off as concerns for the

nation's finances resurfaced following the government's U-turn

on welfare cuts.

UK Prime Minister Keir Starmer's office rushed to give

Finance Minister Rachel Reeves his full backing as analysts

speculated she could lose her job after she appeared visibly

upset in parliament.

Reeves has repeatedly emphasised her commitment to

self-imposed fiscal rules, limiting the amount Britain will

borrow to try to build the confidence of investors.

Euro zone yields rose in tandem, especially those of the

more indebted southern European countries.

"Recent market reaction reflects the market concerns on the

credibility of the government to bring down fiscal deficits,"

said Jefferies economist Mohit Kumar.

"We have a spillover effect from gilts onto European govvies

(government bonds) particularly on countries with weaker fiscal

dynamics," Kumar added.

Germany's 10-year yield, the euro zone's

benchmark, was up 5 basis points at 2.616%, rising to its

highest since May 23.

10-year yields in France, Italy and

Spain, which have higher debt-to-GDP than Germany,

rose between 6 and 7 bps.

Britain's 10-year yield was last up 14.5 bps at

4.602%, having earlier risen as high as 4.681%, its highest

since June 9.

Investors in bonds around the world are growing increasingly

nervous about government deficits from Japan to the United

States, though Britain is seen as among the more vulnerable.

Germany recently approved its draft budget for 2025 and a

budget framework for 2026 which included increased borrowing and

record investment to revive the economy.

Germany's two-year yield, which tends to be the

most sensitive to changes in interest rate expectations, was up

1.5 basis points on Wednesday at 1.86%.

Investors fully expect the European Central Bank to pause

its interest rate cutting cycle when it meets later this month,

as inflation returned to the 2% target in June, data showed on

Tuesday.

Two ECB policymakers warned on Tuesday about the hit from a

further appreciation of the euro on a weak euro zone economy

that is bracing for higher U.S. import tariffs.

Money markets show traders are pricing about a 90% chance of

one more quarter-point rate cut this year from the ECB, which

would bring the benchmark deposit rate to 1.75%, from 2% now.

"ECB officials agree that after cutting interest rates by

200 basis points, 2% inflation and 2% interest rates could be a

sustainable sweet spot to go through trade policy uncertainty

and geopolitical risks," said SGH Macro president Sassan

Ghahraman.

The 90-day pause that Trump activated following the market

chaos unleashed by his April 2 "Liberation Day" tariff

announcement expires in a week.