* US air strike kills Iranian commander
* US, German Bund yields tumble
* Spanish borrowing costs at lowest in almost two months
* Euro zone periphery govt bond yields tmsnrt.rs/2ii2Bqr (Updates prices, adds German national inflation number)
By Dhara Ranasinghe
LONDON, Jan 3 (Reuters) - Government bond yields across the euro area fell on Friday after a U.S. air strike killed a top Iranian commander, marking a dramatic escalation in a “shadow war” in the Middle East between Iran and the United States and its allies.
Germany’s 10-year safe-haven Bund yields slid to two-week lows, Spanish yields hit their lowest in almost two months and borrowing costs in Italy tumbled almost 10 basis points at one point in holiday-thinned trade.
The overnight attack in Baghdad on Qassem Soleimani, Tehran’s most prominent military commander, was authorised by U.S. President Donald Trump. Iran on Friday threatened to hit back hard.
Unease rippled across world markets, with oil prices soaring almost $3 and safe-haven assets such as the Swiss franc, Japanese yen and U.S. Treasuries rallying.
“Markets still remain quite thin after the holidays, but even in a regular session we would have seen a similar reaction,” said Christian Lenk, a rates strategist at DZ Bank in Frankfurt. “The repercussions from the air strike are not clearly forecastable and tensions remain high in the region.”
Yields on German bonds, regarded as one of the safest assets in the world, were sharply lower across the curve.
The 10-year Bund yield fell 7 basis points to a two-week low of -0.30%, almost 15 bps below seven-month highs hit just a day ago.
Across the euro zone, 10-year bond yields were down 6-7 bps in late trade. U.S. 10-year Treasury yields hit their lowest in three weeks at around 1.80% .
The focus on geopolitics meant markets paid little attention to stronger-than-expected inflation data from France and Germany.
French inflation rose 1.6% year-on-year in December, beating analyst expectations for a 1.4% rise.
German inflation rose by 1.5% year-on-year after posting a 1.2% increase in the previous month, higher than forecast but still well below the European Central Bank’s near 2% target.
Signs that economic indicators are bottoming out, and U.S.-China trade tensions are easing, have boosted hopes for growth and inflation in the euro zone. They had pushed euro zone yields to multi-month highs on Thursday.
“Even if you take geopolitics out, most of the positive news is there (in the price),” said Salman Ahmed, chief investment strategist at Lombard Odier.
“But for me, there is a natural boundary in how much interest rates can move higher - we are not expecting a major ramp-up in growth or inflation, inflation is way below target.”
Investors received a reminder of just how fragile the global economy is from U.S. Institute for Supply Management (ISM) data that showed manufacturing in the United States contracting by the most in more than a decade.
Spain’s 10-year bond yield fell to its lowest in almost two months at 0.37% following news that a Catalan separatist party plans to abstain during parliament’s upcoming vote to confirm Socialist leader Pedro Sanchez as prime minister.
The move could end prolonged political deadlock that left Spain without a proper government for most of 2019.
Reporting by Dhara Ranasinghe; additional reporting by Sujata Rao; editing by Larry King and Pravin Char