French bond yields steady as snap election worries ease, new PM awaited

By Samuel Indyk

LONDON, Oct 9 (Reuters) - French bonds on Thursday held on to gains from the day before on optimism the country can avoid a snap election and agree a budget, after talks between caretaker Prime Minister Sebastien Lecornu and other political leaders.

Lecornu resigned on Monday after failing to reach compromises with other parties on fixing the country's shaky finances, and was tasked by President Emmanuel Macron with defusing the crisis.

Macron said on Wednesday that a new prime minister would be named within 48 hours and that most lawmakers were against snap elections, but investors remain wary about France's ballooning budget deficit.

"If there is not a credible path to rein in the deficit, then it suggests France will continue to have the same problems for the foreseeable future," said Salomon Fiedler, economist at Berenberg.

SHORT-TERM RELIEF FOR MARKETS

France's 10-year bond yield FR10YT=RR was 0.2% higher on the day at 3.529%, after falling 5.5 basis points (bps) the day before on optimism that a deal to avoid new elections could be reached. It rose 6 bps on Monday after Lecornu's resignation.

Bond yields move inversely to prices.

Germany's 10-year bond yield DE10YT=RR, the benchmark for the euro area, was up 3 bps to 2.705%, pushing the spread between France and Germany's 10-year yields to 82.2 bps, down from nearly 88 bps on Monday.

The gap premium investors require to lend to France rather than Germany remains elevated and is among the highest in the euro zone.

"Whilst we understand that avoidance of fresh elections will be a relief for markets, it is hard to see a budget that does little to tackle fiscal sustainability being a massive spread tightener over the medium term," RBC Capital Markets analysts said in a note.

POLITICS ASIDE

On Thursday, the accounts of the European Central Bank's notes from their September 10-11 meeting showed policymakers are in no hurry to cut interest rates again, even if they are keenly aware of unusually high uncertainty and risks.

"The current level of interest rates should be seen as sufficiently robust in managing shocks, in view of two-sided inflation risks and taking into account a broad range of possible scenarios," the accounts of the meeting showed.

The ECB kept rates unchanged last month and dampened expectations for future rate cuts, saying the economy was in a "good place".

"They will probably be on hold this year and next year as well," Berenberg's Fiedler said.

"I don't think they'll react to any of the French turbulence that we see now."

Futures imply just a 10% probability of a rate cut by year-end.

Germany's two-year yield DE2YT=RR, which is sensitive to alterations in interest rate expectations, was 0.1% higher at 1.997%.