Euro zone yields rise amid U.S.-Russia talks, French risk premium fades

Updates paragraphs 1-2 with latest rise, adds analyst quote in paragraph 5, graphic, details and analyst on Italy, Germany, France in paragraphs 8-16

By Harry Robertson

LONDON, Feb 19 (Reuters) - Euro zone bond yields rose to their highest in more than two weeks on Wednesday as investors focused on potential extra borrowing to fund higher defence spending amid U.S.-Russia talks over the war in Ukraine.

Germany's 10-year bond yield DE10YT=RR, the benchmark for the euro zone bloc, rose 4 basis points (bps) to 2.529%, the highest since Jan. 31. Yields rise as prices fall and vice versa.

Benchmark German yields have risen around 9 bps this week after U.S. President Donald Trump shocked allies by initiating talks with Russia over ending the Ukraine war, and figures in his administration said Europe will have to shoulder more of the security burden.

That implies higher spending on defence and so higher borrowing via bond markets, adding to upward pressure on yields.

"All of a sudden not only politicians but also markets seem to be waking up to the reality that there will be substantially more defence spending, and that will have to be financed somehow," said Jussi Hiljanen, head of European rates strategy at SEB.

Investors were also digesting the latest tariff threats from Trump, who said he intends to put a roughly 25% levy on cars. Elsewhere, UK inflation came in stronger than expected, rising to 3% in January from 2.5% in December.

SPREADS TIGHTEN

​Italy's 10-year yield IT10YT=RR was up 5 bps at 3.594%, also its highest since late January.

The gap between Italian and German 10-year yields DE10IT10=RR - a gauge of the extra premium investors demand to hold Italian debt - stood at 105 bps, not far from the more than three-year low of 101 bps touched on Friday.

The spread between French and German 10-year bond yields ended at its lowest closing level since July at 66 bps on Tuesday and hovered around there on Wednesday DE10FR10=RR.

The risk premium on French debt shot higher last summer when President Emmanuel Macron called elections that resulted in a hung parliament and political stasis.

Yet the eventual passing of a budget earlier this month has cooled concerns among investors about the economy.

Benjamin Schroeder, senior rates strategist at ING, said the prospect of closer European cooperation over borrowing might be narrowing the gap between euro zone yields.

SEB's Hiljanen said positive sentiment among investors as Trump appears to be holding off from dramatic tariffs was likely the driver.

Germany's two-year bond yield DE2YT=RR, which is influenced more by European Central Bank rate bets than expectations about borrowing, was 2 bps higher at 2.149%.