Bund yields struggle for direction after German elections

By Stefano Rebaudo

Feb 24 (Reuters) - Euro area benchmark Bund yields struggled for direction on Monday as the outcome of German general elections supported expectations for pro-growth policies, though uncertainty remained over potential reforms to increase fiscal spending.

Germany's likely next chancellor, Friedrich Merz, will start trying to form a coalition government on Monday after his conservative bloc won a national election that saw far-right and far-left parties gain support from disaffected voters.

"We expect a two-party coalition between the (conservative bloc) CDU/CSU and the centre-left SPD to enact some pro-growth supply-side reforms," said Holger Schmieding, chief economist at Berenberg Bank.

He argued that populist parties from the political fringes, such as Alternative for Germany (AfD) and The Left, "can veto any loosening of the debt brake enshrined in the constitution".

Investors have pinned hopes on a new government reforming the so-called debt brake to increase fiscal spending and boost the economy, especially given the pressure from the U.S. government for European countries to pay more for defence.

Germany's 10-year bond yield DE10YT=RR, which serves as the benchmark for the wider euro zone, was down 0.5 basis points (bps) at 2.46%, after rising around 2 bps in early trade.

The Left has campaigned for lowering defence spending, but they are in favour of higher infrastructure investments and abolishing the debt brake.

"There could, therefore, be a cross-party consensus with the Left on setting up an off-budget infrastructure fund or exempting infrastructure investment from the debt brake to create more room for defence spending in the core budget," creating some "room for manoeuvre," according to Deutsche Bank.

The 2-year yield DE2YT=RR dropped one bp to 2.09%.

Merz will probably face lengthy coalition negotiations after the far-right Alternative for Germany (AfD) surged to a historic second place after Chancellor Olaf Scholz's three-way alliance collapsed.

"The risk that coalition building fails because the CDU/CSU pulls out or SPD members vote down the result is significant, in our view," said Christian Schulz, an economist at Citi.

"That could lead to either a minority government or snap elections," he added.

Schulz highlighted the differences between the two parties, saying that the CDU/CSU campaigned to enhance competitiveness by cutting taxes for business, while SPD campaigned for a demand boost, with another minimum wage hike and a 100 billion euros public investment fund.

Italy's 10-year yield IT10YT=RR was down 0.5 bps at 3.55%. The yield gap between Italian and German yields DE10IT10=RR widened to 108.5 bps.