June 3 (Reuters) - Euro zone government bond yields rose

on Wednesday, with traders now pricing in a more than 50%

probability of three European Central Bank rate hikes by

year-end as U.S.-Iran peace talks stalled.

Investors stayed wary about the possibility of a deal

between the U.S. and Iran that could reopen the Strait of

Hormuz, as such a development would likely reduce energy-driven

inflationary pressures and weaken expectations of further

central bank tightening.

Gulf hostilities flared again on Wednesday as an Iranian missile

attack damaged Kuwait's airport and the U.S. military carried

out strikes near the Strait of Hormuz.

Money markets are pricing the ECB deposit rate at 2.66% by

December, which implies two rate hikes and

an about 65% chance of a third move. They also indicated a 90%

chance of a first rise this month.

The ECB is expected to raise its deposit rate to 2.25% on June

11, with another increase likely in September, as it balances

energy-driven inflation against a weakening economy, a Reuters

poll of economists showed.

Germany's 2-year yields, more sensitive to

expectations for policy rates, rose 5 basis points (bps) to

2.67%. They reached 2.771% in late March, the highest since July

2024.

Markets are closely watching the ECB's possible rate

outlook, while a likely future increase in fiscal spending is

also under the spotlight.

"This is the third energy crisis for Europe since 2000. We

had COVID, Ukraine, Iran, each one of these crises required

fiscal spending because governments need to support the industry

and the consumer," Yoram Lustig, head of global investment

solutions at T. Rowe Price, said.

"This is bad for government bonds," he added.

Germany's 10-year government bond yield, the euro

area's benchmark, was up 4.5 bps at 3.02%. It reached 3.13% in

late March, its highest level since June 2011.

Investors are also looking ahead to the U.S. employment

report due on Friday, which could shape the Federal Reserve's

policy path.

A stable labour market would reinforce financial market

expectations that the Fed will keep rates stable into next year,

while monitoring the inflation fallout from the Middle East

conflict.

Italy's 10-year government bond yields rose 6 bps to

3.76%, with the yield gap of Italian government bonds versus

Bunds at 72 bps.