German yield curve heads for fourth week of steepening

By Stefano Rebaudo

July 18 (Reuters) - The German bond yield curve was heading for its fourth straight week of steepening, as investors shifted their focus to expansionary fiscal plans, pushing long-dated yields higher while the short-dated ones held steady.

Euro zone government bond markets also took cues from U.S. Treasuries, where 10-year yields rose amid concerns over the Federal Reserve's independence and a potential inflation resurgence driven by tariffs.

German two-year government bond yields DE2YT=RR – more sensitive to expectations for European Central Bank policy rates – rose one basis point to 1.85% on Friday. They were around the same levels in early June.

Germany’s 10-year government bond yield DE10YT=RR, the euro zone's benchmark, climbed two bps to 2.69%. It was at around 2.48% in early June.

The gap between German 10-year and two-year yields DE2DE10=RR is on track for a 4 bps rise this week. It’s also set to post a significant monthly increase in July, following a period of stability since April.

Economists expect the European Central Bank to keep rates on hold at its policy meeting next week, while possibly reducing them again in September when there will be more clarity about the economic impact of tariffs and the outcome of trade negotiations between the U.S. and the European Union.

"If, on August 1st, the U.S. increases tariffs on Europe, I would expect some retaliation from the EU, so there is a risk of a tit-for-tat escalatory round," said Paul Hollingsworth, head of developed markets economics at BNP Paribas.

"But that still seems like the tail risk rather than the central case right now. A deal still looks likely to be done before August 1st," he added.

Money markets still priced in around a 90% chance of a 25 bps ECB rate cut by December EURESTECBM4X5=ICAP, and a roughly 40% chance of that move happening in September EURESTECBM2X3=ICAP.

"We have to be prepared to have an asymmetrical tariff agreement, but once again with the lowest possible rates on both sides," German Chancellor Friedrich Merz said on Friday.

Italy’s 10-year government bond yields IT10YT=RR were up 2 bps at 3.58%, with the spread between Italian and German bond yields - a market gauge of the risk premium investors demand to hold Italian debt - at around 88 bps, near recent multi-year lows.

“We're relatively constructive when it comes to spreads. We think that this tightening that we've seen has been justified by fundamentals,” BNP Paribas’ Hollingsworth said, recalling that the fiscal backdrop is not deteriorating in the bloc's so-called peripheral countries while their economies are growing.

Analysts are more cautious on France as risks of a no-confidence motion in the government would likely intensify once a detailed budget bill is presented to parliament in October.

French Prime Minister Francois Bayrou proposed a 43.8 billion euro fiscal squeeze on Tuesday, which left-wing and far-right politicians immediately criticised.

French 10-year yields FR10YT=RR were up 2 bps at 3.40%, with the gap between French and German yields DE10FR10=RR - a market gauge of the risk premium investors demand to hold French debt - at around 70 bps.