Updates with afternoon trading

By Stefano Rebaudo

April 2 (Reuters) - Euro zone bond yields were set for a weekly fall on Thursday after moving higher early in the day on the latest headlines about the Iran conflict, with traders seeking to position ahead of a long weekend.

Yields rose sharply early in the session and traders once again priced three 25-basis-point European Central Bank rate increases, after U.S. President Donald Trump vowed more aggressive strikes on Iran in a Wednesday evening prime-time speech.

Tehran will press on with the Middle East war until the U.S. and Israel face "permanent regret and surrender", a spokesperson for Iran's armed forces' unified command said.

But the early spike in yields gradually reversed throughout the day as investors reconsidered the possibility of deescalation and dozens of countries sought ways to restart vital energy shipments through the Strait of Hormuz.

Germany's 10-year Bund yield, the benchmark for the euro zone, was last at 2.99% a fraction lower on the day, having earlier traded as high as 3.05%.

It is set for a 10-basis-point fall this week as traders try to refine their positions, but is still around 35 bps higher than it was before the war began as surging energy costs have fuelled inflation fears and expectations for rate hikes at the ECB and elsewhere.

Money markets last priced at least two 25 bp rate increases from the ECB with around an 80% chance of a third. The number of expected cuts has come down slightly this week, but before the war began markets had seen a small chance the ECB would cut rates this year.

"As time goes on the 'good' scenario in which rate hikes are avoided seems increasingly optimistic," said Chris Attfield, investment analyst at HSBC Global Research.

"With evident concern from ECB speakers about second-round effects, including such doves as (Fabio) Panetta, it is possible that the first hike could come as soon as 30 April," he added.

In the current uncertain geopolitical environment it is important that rising costs and prices do not trigger second-round effects on wages, Panetta said on Tuesday. Panetta mentioned on Thursday concerns for potential repercussions on financial stability.

Germany's 2-year yields DE2YT=RR, more sensitive to expectations for policy rates, were flat at 2.61%. They were on track for a 6-bp weekly decline.

ITALIAN SPREAD UNDER PRESSURE

Italy's 10-year government bond yields IT10YT=RR were also close to flat at 3.869% towards the end of trading on Thursday, having earlier traded up around 8 bps.

The yield gap between Italian government bonds and Bunds stood at 86 bps, down from close to 100 bps last week but still well up from 63 bps before the start of the war, and 53.50 in mid-January, its lowest level since August 2008.

With a large public debt stock, Italy is particularly exposed to a scenario of rising interest rates, which would increase its debt-servicing costs.

"We move to mildly bearish for the non-core, specifically Italy, and forecast the 10-year BTP-Bund spread at 100 bps by the end of second quarter," HSBC's Attfield argued.

"However, we think this could rise to 140 bps in an adverse scenario. In that situation, ECB intervention using the Transmission Protection Instrument is a possibility."

The French spread over Bunds was at 70 bps DE10FR10=RR from 58 bps before the conflict.