Euro area benchmark Bund yields flat after German elections

updates latest price moves

By Stefano Rebaudo

Feb 24 (Reuters) - Euro area benchmark Bund yields ended Monday largely unchanged as the outcome of German general elections supported expectations for pro-growth policies, though uncertainty remained over potential reforms to the debt brake and increased 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 hoover up 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 populist parties from the political fringes, such as Alternative for Germany (AfD) and the Left party, "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.

Elsewhere, German business leaders called for the swift formation of a new government after Sunday's election, saying Europe's largest economy could not afford to waste any time as companies suffer from high costs, red tape and rising competition from abroad.

Germany's 10-year bond yield DE10YT=RR, the benchmark for the wider euro zone, was virtually unchanged at 2.68%.

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

"There could 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, more sensitive to European Central Bank policy rates, was up 0.2% at 2.339%.

"I think there will be more spending on infrastructure investments and defence no matter what happens with the debt brake," said Carsten Brzeski, global head of macro research at ING. "That should increase the Bund supply."

Business morale in Germany unexpectedly stagnated in February.

"The election results are consistent with our base case of a pro-growth shift in economic policy under a coalition, which would include some modest fiscal easing," said Mark Haefele, global wealth management chief investment officer at UBS.

Merz could face lengthy and complex coalition negotiations after a surge in support for the AfD and far-left.

"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.

Citi's Schulz highlighted the differences between the two parties, mentioning 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 also flat at 3.557%. The yield gap between Italian and German government bonds DE10IT10=RR was 108 bps.

Markets are also mulling over the European Central Bank policy path after ECB officials recently warned about excessive monetary easing.

Policymaker Pierre Wunsch said the euro zone faces the risk of "sleepwalking" into excessive interest rate cuts and must be prepared to stop lowering borrowing costs soon.

Money markets priced in an ECB depo rate at 1.835% in December EURESTECBM7X8=ICAP from over 2% on Friday before PMI data as the uncertainty about the German economy weighed.