* Yields rise across German curve on ECB hike expectations
* 10-yr yield hits 3.5 pct for first time since August 2009
* EU/U.S. spread narrows as monetary policy cycles diverge
* Portuguese yields steady awaiting bailout deal terms
By William James
LONDON, April 11 (Reuters) - Germany's cost of borrowing over 10 years topped 3.5 percent for the first time since August 2009 on Monday and was set to rise further as expectations of higher euro zone interest rates drove yields higher across the curve.
The European Central Bank has pointed markets towards further rises in rates this year after last Thursday's 25 basis point increase, prompting investors to skew their positions towards a next rise coming in June rather than July.
"It is very much a macro story that is driving the Bund market now... it's now a story about the ECB, inflation and core European macroeconomic performance," said Niels From, chief analyst at Nordea in Copenhagen.
The Schatz yield
Bund futures
Moves on the day were small but German yields have been on a rising trend after bouncing off the 38 percent retracement level of the 2008-2010 fall at 3.1 percent in mid-March, and the next target is the 62 percent retracement around 3.7 percent.
DZ Bank strategist Glenn Marci expects Bunds to yield 3.8 percent at the end of this year and 4 percent by next April, with Treasury yields at 4 percent at the end of the year and 4.3 percent in 12-months.
U.S. Treasuries outperformed Bunds, with the yield spread
Donal O'Mahony, global strategist at Davy Stockbrokers said the recent weakening of Bunds versus Treasuries may reverse in the second part of the year as Federal Reserve officials turn more hawkish, and comments following the Fed's April meeting may offer the first signs of that shift.
"As we move through the year you will see Fed policymakers becoming more hawkish and that perhaps ... is when cross-Atlantic spreads will be widening again," O'Mahony said.
BAILOUT
Portuguese bond yields were steady as officials from the European Commission, the ECB and the IMF readied for talks in Lisbon on Tuesday over the details of the country's bailout.
Traders said Portuguese debt was likely to trade sideways until the conditions of the aid deal -- key to assessing Portugal's long-term viability as an investment -- are known.
Greek bond yields were steady despite media reports that finance ministers believed Greece was unlikely to meet fiscal targets, but traders said tensions could resume if talk about restructuring intensified.
"They are stating the obvious, but restructuring is not something you would want to hear even if many already expect significant haircuts," a trader said.
By assuming investors will recover 40 percent of their original investment, Davy Stockbrokers' Donal O'Mahony says the market is pricing in a 61 percent probability of a default based on three-year CDS levels -- currently at around 1,220 bps.
The annual cost of insuring 10 million euros worth of debt over three years would be 1.22 million euros. This means investors are paying an insurance rate of 61 percent to protect against expected losses of 6 million euros.
(Editing by Patrick Graham)