Bond investors shrug off Merz's failure to be elected chancellor

By Yoruk Bahceli

LONDON, May 6 (Reuters) - German bond yields pulled back from three-week highs on Tuesday as German conservative leader Friedrich Merz failed to garner the parliamentary majority needed to become chancellor.

The news is an unexpected setback for his new coalition with the centre-left Social Democrats, which has investors bracing for measures to boost Germany's ailing economy just as tariffs take their toll.

Lawmakers now have 14 days to elect Merz or another candidate chancellor with an outright majority. A second vote won't be held on Tuesday, the Frankfurter Allgemeine newspaper reported. If Merz still fails to win an outright majority after 14 days, he can still be elected by a simple majority.

While economists said Tuesday's move signalled a potentially challenging outlook for policy, the two parties had already voted to create a 500 billion-euro ($565.75 billion) infrastructure fund and overhaul a constitutional borrowing limit to increase defence spending during the previous parliament's term.

Bond market reaction to Tuesday's surprise was limited. Germany's 10-year yield DE10YT=RR briefly turned lower on the day, having risen to a three-week high at 2.555% earlier.

By 1018 GMT, it was up 2 basis points (bps) to 2.54%.

"The Rubicon has been crossed. Germany has the ability to spend beyond the previous confines or limitations of the constitutional debt brake," said Richard McGuire, head of rates strategy at Rabobank in London.

"Who's leading the country determines its willingness to do that... but judging by the market's reaction, it seems that perhaps Merz's having failed the first vote is seen as a temporary stumbling block rather than heralding a possible change in political direction," he added.

The plans to boost spending are seen as a game changer for Germany's economy and bond markets. Their shock announcement in March pushed German borrowing costs to post their biggest weekly jump since the 1990s and euro zone bond yields rose across the board as investors braced for additional borrowing and stronger growth.

But Germany's borrowing costs dropped sharply in April as investors took refuge in the market as a safe haven amid a searing selloff in U.S. Treasuries driven by tariff fears that raised questions about the status of the world's biggest bond market.

Another focus on Tuesday was debt sales. Germany saw over 47 billion euros of investor demand for a re-opening of an outstanding 30-year bond that will raise 4 billion euros in a syndication, according to a lead manager memo seen by Reuters.

The U.S. will auction $42 billion in 10-year notes. Investors will continue to keep a close watch for any signs of diminishing demand for Treasuries.

Elsewhere, final euro zone business activity data for April showed activity holding up slightly better than initially estimated, with the services sector avoiding a contraction.

($1 = 0.8838 euros)