Euro zone yields drop on U.S. data; French-German spread widest in nearly 7 months

By Stefano Rebaudo and Canan Sevgili

Sept 26 (Reuters) - Euro zone government bond yields fell on Friday, reversing the previous day's rise, as fixed income market volatility remained at low levels with the European Central Bank expected to keep interest rates on hold until the end of 2026.

Borrowing costs reacted marginally to U.S. data which showed U.S. consumer spending matched expectations.

Germany’s 10-year Bund yields, the bloc’s benchmark, dropped 3.5 basis points (bps) to 2.73%. It had been falling by 3 bps right before the U.S. data.

Analysts said U.S. Treasuries have taken the lead in the euro area’s fixed income market this week, with investors uncertain about the Federal Reserve’s easing path.

Thursday’s U.S. economic data cast doubt on market expectations for Fed policy, prompting traders to scale back bets on future rate cuts to 100 bps by the end of 2026, while pricing in an 80% chance of an easing move next month.

Traders priced in an around 40% chance of a 25 bps rate cut by the ECB by July EURESTECBM7X8=ICAP. The key rate is seen at 1.97% in December 2026 from 2% currently. EURESTECBM11X12=ICAP

U.S. Treasuries were slightly lower with Benchmark 10-year yield US10YT=RR down one bp at 4.16%.

Investors are also assessing the potential impact of planned increases in German fiscal spending, which could help revive euro area growth and lift inflation.

Germany's economy is emerging from a trough and is expected to regain some momentum over the next two years, five leading economic institutes said on Thursday, a day after data showed an unexpected decline in business morale.

"In the past, the government often did not manage to spend all the money it had allocated to certain projects in any given year," said Holger Schmieding, chief economist at Berenberg.

"Although Germany is trying to speed up approval processes, we continue to expect expenditures to rise less quickly than planned," he added.

Germany’s 2-year yields DE2YT=RR, more sensitive to expectations for ECB policy rates, fell 1.5 bps to 2.03%.

German Chancellor Friedrich Merz is pushing for the European Union to unlock up to 140 billion euros ($164 billion) in frozen Russian assets to finance Ukraine's war effort, the first public expression of support at this level from Berlin for such a move.

"The obvious solution is more joint EU issuance, initially backed by voluntary bilateral guarantees from participating EU member states, and later by the EU budget," said Christoph Rieger head of rates and credit research at Commerzbank.

"For EU (government bond yield) spreads, unless the funding needs to be raised very quickly, this could actually be positive," he added, arguing the "EU could establish itself as a more permanent issuer for longer."

The prospect of increased joint issuance in the euro area could support bond prices in the most indebted countries, as shared borrowing tends to reduce risk premiums and signal stronger fiscal solidarity across the bloc.

However, the yield gap between safe-haven Bunds and 10-year French government bonds DE10FR10=RR — a market gauge of the risk premium investors demand to hold French debt — is stable around 82 bps, after hitting 83.80 bps, its highest in almost seven months.

French unions will hold another day of strike and protests on October 2 to put pressure on new Prime Minister Sebastien Lecornu over their demands to scrap fiscal austerity plans.