Euro zone borrowing costs rise as investors see more defence spending ahead

Updates prices

By Alun John

LONDON, Feb 18 (Reuters) - Longer-dated euro zone yields rose to two-week highs on Tuesday, extending the increases of the previous day when investors sold bonds on expectations that European governments would ramp up issuance to fund bigger defence spending.

Germany's 10-year bond yield DE10YT=RR, the benchmark for the euro zone bloc, rose as much as 3 basis points (bps) to 2.517%, its highest since Jan. 31.

The euro zone benchmark had risen 6 bps on Monday following remarks by European leaders that they would have to hike defence spending in response to the U.S. being less willing to take the lead on Europe's defence, likely requiring greater borrowing.

The U.S. and Russia said on Tuesday they had agreed to press ahead with efforts to end the war in Ukraine after holding talks in the Saudi capital at which Kyiv was not represented.

"The message (from the U.S.) is clear - Europe has to defend itself moving forward, and that will take a lot of investment and spending, and markets are playing close attention to how it will be financed," said Michiel Tukker, rates strategist at ING.

He added, however, that while yields were higher, by and large markets were taking the prospect of increased issuance in their stride.

"Markets are so far quite content with the EU spending more. It could have led to a panic reaction - look at France where the fiscal picture is quite challenging - but there is a sense that the EU needs to do something and it would be more worrying to markets if the EU does nothing," he said.

The gap between French and German 10-year yields DE10FR10=RR was last at 66.5 basis points, on track for its narrowest close since July 2024, having been helped by the relative if uneasy calm in French politics.

European equities are also at record highs, and credit spreads are tight. .EU

The medium- to long-term implications of a peace deal in Ukraine are more complicated for the outlook for euro zone bonds, investors and analysts say, as it depends on how the ECB balances lower energy costs - and potentially lower inflation - with possibly higher longer-term growth rates.

The other near-term focus for bonds, said Tukker, was Sunday's German election.

Investors say Europe's largest economy would not be punished by financial markets if it chooses to increase borrowing, but much depends on the outcome of the election.

Peripheral debt was slightly outperforming Bunds on Tuesday, with Italy's 10-year yield IT10YT=RR last 0.5 bps lower at 3.54%. Its spread with German Bunds was narrower at 104 bps.