French, euro zone bond yields fall on French budget hopes

By Alun John

LONDON, Oct 8 (Reuters) - French bonds outperformed their euro zone peers on Wednesday on the possibility that the country's parliament may agree a budget by the end of the year, despite the ongoing political crisis.

The mood was much calmer than earlier in the week when developments in French and Japanese politics sent yields higher worldwide, but with bond markets having been under pressure for much of the year, the calm is unlikely to last.

French caretaker Prime Minister Sebastien Lecornu, who tendered his resignation on Monday, struck a cautiously optimistic tone earlier in the day, saying a deal could potentially be reached on the country's budget by year-end, making the possibility of a snap election less likely.

That sent the yield on France's 10-year bond FR10YT=RR to its lowest since September 18 at 3.505%. It was last down 5 basis points on the day at 3.52%, having traded close to 3.6% on Monday and Tuesday after the resignation of Lecornu, France's fifth prime minister in less than two years. Bond yields move inversely with prices.

GERMANY'S 10-YEAR YIELD DOWN 3 BPS

Germany's 10-year yield was down 3 bps at 2.679% DE10YT=RR, narrowing the gap between French and German 10-year yields to 84 bps down from nearly 88 bps on Monday. <FR10DE10=RR>

The gap, the premium investors require to lend to France rather than Germany, remains elevated and is among the highest in the euro zone.

Analysts were wary of getting too excited about Wednesday's move in French yields.

"I suspect there is some short covering going on, but it doesn't really change the context," said Kenneth Broux, head of corporate research FX and rates at Societe Generale, pointing to France's large deficit.

"The risk premium in OATs (French government bonds) may be here to stay for a while."

Lecornu was set to be interviewed on French TV about 8 p.m. (1800 GMT), though the leader of France's Socialist Party Olivier Faure said they could not back the government's budget plan as it stands.

France aside, there was little else for euro zone bond investors to process.

Data showed German industrial output fell much more than expected in August due to a sharp decrease in production in the car industry. But with the European Central Bank seemingly firmly on hold for now, it would take a lot more bad economic news to raise bets on a further rate cut this year.

Germany's rate-sensitive two-year yield dipped 1.5 basis points to 1.987%. DE2YT=RR

Earlier, Japanese government bonds were also calmer following a tumultuous few days as speculation swirled about the course of the country's fiscal policy. JP/

Still to come on Wednesday is the release of minutes of the latest meeting of the U.S. Federal Reserve's rate setting committee. It would not typically be market moving, though due to the U.S. shutdown causing an absence of major economic data, the minutes could take on greater significance.