Euro zone bond yields surge as markets brace for jump in defence spending

Updates in late European trading

By Alun John

LONDON, March 3 (Reuters) - Euro zone government bond yields rose sharply on Monday as investors processed the weekend's dramatic geopolitical developments, which will likely require greater European borrowing to spend on defence.

Germany's 10-year bond yield DE10YT=RR, the euro zone's benchmark, rose as much as 13 basis points (bps) to 2.519% and was last trading at 2.497%, up 11 bps.

Germany's 30-year bond yield DE30YT=RR rose as high as 2.827% and was last up 12 bps, set for its biggest daily rise since April. Yields rise as prices fall.

The move, which lifted yields from Friday's two-week lows, came after European leaders agreed at a summit in London on Sunday that they must spend more on defence.

The summit followed a disastrous meeting between U.S. President Donald Trump and Ukrainian President Volodymyr Zelenskiy in the Oval Office on Friday.

The European Commission chief suggested the bloc could ease rules that limit debt levels.

In addition, Reuters reported, citing sources, that the parties in talks to form Germany's new government are considering quickly setting up two special funds, potentially worth hundreds of billions of euros, one for defence and a second for infrastructure.

Samy Chaar, chief economist at Lombard Odier, said Monday’s selloff was a result of investors starting to appreciate that the growth outlook could be evolving.

"After the German elections there is more and more talk about defence spending, and if not infrastructure spending," he said.

The Reuters report, "even if just a rumour tells you that sentiment is shifting. It does seem like the Europeans think that the status quo and doing nothing is not possible - they can disappoint, but they can’t do nothing," said Chaar.

The same trend was even more evident in stock markets, where defence companies such as BAE systems, BAES.L Thales TCFP.PA and Rheinmetall RHMG.DE were all up over 15%.

STEEPER CURVE

There was a clear move towards a steeper yield curve, meaning investors were demanding a greater premium to hold longer-dated than short-term debt, which is typically anchored by central bank rate expectations.

The German two-year yield was up 6 bps at 2.079% DE2YT=RR on Monday.

The 10-year yield was as much as 41 bps above the two-year, the biggest difference since October 2022, before the European Central Bank began its latest round of rate increases. DE2DE10=RR

Also notable was the contrast with the United States, where fears about the health of the economy have been pushing yields down.

German 10-year yields were last 170 bps below those of U.S. Treasuries, the smallest gap since October. DE10US10=RR US/

Longer-dated bonds were under selling pressure elsewhere in Europe too. Italy's 10-year yield IT10YT=RR was 8 bps higher at 3.549%.

As well as geopolitics, investors were processing euro zone inflation data released on Monday.

Inflation dropped a bit less than expected last month but a fall in both core and services inflation reinforced the case for a further ECB interest rate cut on Thursday.