(Updates prices, adds data on Japanese selling)
By Dhara Ranasinghe
LONDON, Aug 8 (Reuters) - Euro zone bond yields fell on Monday, partly reversing a sharp rise triggered by strong U.S. jobs data last week, though Italy's bonds lagged following a cut to its credit rating outlook.
While some of the market swings stemmed from thinner summer trading conditions, safe-haven bonds also drew some support from geopolitical tensions, as China's military announced fresh drills on Monday in the waters and airspace around Taiwan.
The Chinese military made its announcement a day after the scheduled end of its largest ever exercises to protest last week's visit to Taipei by U.S. House of Representatives Speaker Nancy Pelosi.
Germany's 10-year Bund yield was down about six basis points at 0.896%. French and Dutch 10-year yields were down similarly. .
A slight rise in euro zone investor morale in August was too little to stave off recession fears, a survey showed.
German bond yields had risen 15 bps along with U.S. Treasury yields on Friday in their biggest one-day surge since March 2020, after data showed the U.S. economy created 528,000 jobs in July, stoking expectations for a big U.S. interest rate hike next month.
"It's a slight reversal of Friday's move, but bear in mind that the next two weeks will be a thin trading environment," said Peter McCallum, rates strategist at Mizuho, referring to the fall in euro zone bond yields.
A rise in U.S. interest rate-hike bets for September was mirrored in the euro zone, with money markets pricing in about a 90% chance of a 50-basis-point rate rise by the European Central Bank in September, from roughly a 50% chance a week ago.
Italian bonds underperformed, with 10-year yields at around 3.03% - flat to marginally higher towards the close of trading after ratings agency Moody's on Friday cut the outlook on its credit rating to "negative" from "stable".
The downgrade followed a revision of Italy's outlook to stable from positive by S&P Global last month. It came weeks after Prime Minister Mario Draghi's resignation sparked fresh political uncertainty. Moody's said risks to Italy's credit profile had risen due to political developments and the economic fallout of Russia's invasion of Ukraine.
"The same rating action by S&P the other week already prepared markets for a less dovish rating dynamics but failed to cause lasting pressure," said Michael Leister, head of interest rates strategy at Commerzbank.
Data last week showing the ECB had skewed reinvestments from maturing bonds from its Pandemic Emergency Purchase Programme (PEPP) to Italy was expected to support Italian debt.
Italy's bond-yield gap over Germany was around 210 basis points, well below levels that are considered alarming.
Meanwhile, data showed that Japanese investors, big buyers of overseas debt, had sold 3.88 trillion yen ($28.83 billion) worth of U.S. bonds and 926.8 billion yen (6.74 billion euros) worth of European bonds in June. ($1 = 134.5600 yen) (1 euro = 137.4800 yen)
(Reporting by Dhara Ranasinghe, additional reporting by Sujata Rao; Editing by Susan Fenton, Emelia Sithole-Matarise and Paul Simao)