By Dhara Ranasinghe

LONDON (Reuters) -Euro zone bond yields shot up on Tuesday, with two-year German borrowing costs hitting over two-week highs, after a source-based report that the European Central Bank would discuss whether to raise rates by 25 or 50 basis points on Thursday.

The ECB has flagged that it would raise rates by 25 bps at its July policy meeting to contain record high inflation, so news that it could consider a bigger move came as somewhat of a surprise to markets.

Money markets now price in roughly a 60% chance of a 50 bps rate hike this week, up from around 35% on Monday.

“Truth be told, we now have no clue what they will do on Thursday,” said Arne Petimezas, senior analyst at AFS Group.

A Reuters report that Russian gas flows via the Nord Stream 1 pipeline are seen restarting on time on Thursday after the completion of scheduled maintenance also pushed yields higher. A shortage of gas supplies from Russia has been seen as potentially pushing some euro zone economies into recession.

Germany’s two-year bond yield, sensitive to near-term rate expectations, climbed around 12 bps to its highest in over two weeks at around 0.66%.

Across the euro area, benchmark 10-year bond yields were around 10 bps higher on the day.

The euro, which last week fell below parity against the dollar for the first time in two decades, was trading 1% higher at $1.0256.

A rate rise from the ECB this week would be its first since 2011 and follows aggressive moves by other major central banks recently to get on top of red-hot inflation.

“It would be surprising if they go for a 50 bps hike because the signalling from the majority of policymakers has been for a 25 bps move,” said Nordea chief analyst Jan von Gerich.

“Given how far they have gone to hold onto their forward guidance, it would be difficult to break from that for now.”

According to the source-based story published by Reuters, policymakers were also homing in on a deal to provide help for indebted countries like Italy on bond markets if they stick to European Commission rules on reforms and budget discipline.

That may have helped support Italy’s 10-year bond yield, which fell back after initially rising on the ECB report. It was last trading at 3.42%, just a touch higher on the day.

Analysts said that deploying a new tool has been complicated by a political crisis in Italy.

Prime Minister Mario Draghi is expected to address parliament on Wednesday after tendering his resignation last week after the populist 5-Star Movement refused to back the government in a confidence vote at the Senate.

That resignation was rejected by President Sergio Mattarella and it is still unclear whether Draghi will change his mind.

“There needs to be more carnage in Italian bonds before the ECB takes action,” said von Gerich.

(Reporting by Dhara Ranasinghe; additional reporting by Yoruk Bahceli in Amsterdam, editing by Ed Osmond and Susan Fenton)