Euro zone bond yields rise, French spread slightly up, fiscal concerns in focus

By Stefano Rebaudo and Amanda Cooper

Dec 19 (Reuters) - Euro zone government bond yields climbed on Friday as traders increased bets on future European Central Bank rate hikes, while French debt moved roughly in line with its peers after lawmakers failed to strike a deal on the 2026 budget.

German government bond yields rose early in the session, after European Union leaders agreed to borrow an extra 90 billion euros ($105.46 billion) over two years to fund Ukraine's defence, rather than use frozen Russian assets to do so.

German 10-year yields DE10YT=RR, which serve as a benchmark for the wider, 20-nation euro zone, were up 4 basis points at 2.88%.

Traders stopped short of boosting their bets on the timing of the first rate hike on Thursday, as U.S. economic data pushed down Treasury yields following the ECB's decision.

However, money markets have returned to levels seen on Thursday before the U.S. data release, pricing a 60% chance of a hike by March 2027 EURESTECBM11X12=ICAP and no change from the current 2% deposit rate until then.

INVESTORS EYE RISK OF SNAP ELECTION IN FRANCE

Markets have already priced in political uncertainty in France and the risk that emergency legislation will be needed until a proper budget is agreed, while the possibility of snap elections could widen the yield spread further.

“We’d need something new, like a concrete risk of general elections, to see OATs underperform their peers,” said Massimiliano Maxia, senior rates strategist at Allianz Global Investors.

French 10-year government bond yields FR10YT=RR rose 5 bps to 3.60%, with the gap versus Bunds up one bp to 72 bps.

Italian bond yields IT10YT=RR rose 4 bps for a yield of 3.54%. The gap between Italian and German yields was at 65 bps after hitting a fresh 16-year low at 62.75 DE10IT10=RR early in the session.

FISCAL CONCERNS GROW AFTER EU LOAN

"Long-dated bonds are under pressure as fiscal worries mount, and the EU’s move on Ukraine adds to that trend,” Allianz Global Investors' Maxia said.

Germany's 30-year government bond yields DE30YT=RR, more sensitive to long-term fiscal concerns, touched a fresh 14-1/2-year high at 3.547%, and was last up 5 bps at 3.54%.

"We began trimming the position (on 30-year EU bonds) yesterday and profited by closing our position following the announcement that the EU would be financing the Ukraine loan from the budget,” said James Ringer, fund manager at Schroders.

The asset manager was overweight 30-year EU bonds on valuation grounds and on expectations that the heavy net EU bond issuance linked to the Next Generation EU programme was nearing its end.

"We still view the EU as an attractive long-term investment given its AAA rating, and look to any supply concession to start adding back our position," Ringer added.

Germany's 2-year government bond yields DE2YT=RR, more sensitive to the policy rate outlook, rose 1.5 bps to 2.15%.

"The big risk of using Russian assets to fund Ukraine's war effort is that it would cheapen European government paper and lead to higher rates on sovereign bonds. The flipside of that is that I would imagine this adds to the fiscal burden in Europe marginally," Kyle Rodda, senior market analyst at Capital.com, said.

"But I think that's a relatively small cost compared to what would be incurred if governments around the world in certain countries - China is the big one - decide that it's not worth buying European debt, because it could expose them to similar risk."

($1 = 0.8534 euros)