Political Uncertainty Drives Euro Zone Bond Yield Fluctuations

Euro zone government bond yields rose as political uncertainty in France dominated market attention. The European Union announced plans to start disciplinary budget steps against France, Italy, and Belgium due to excessive deficits. French bond yields widened, while German bonds remained a safe investment. Market reactions were muted but cautious.

Euro zone government bond yields rose on Wednesday, while the risk premium that investors demand to hold French bonds inched higher as attention remained on political uncertainty in France. The European Union said on Wednesday it wanted to start disciplinary budget steps against France, Italy, Belgium and other smaller EU countries over their excessive budget deficits, requiring them to reduce their shortfalls. Market reaction was relatively muted as the move was widely expected.

The gap between France and Germany's 10-year yields stood at 74 basis points (bps), up 2 bps from the previous session, but below the seven-year high of 80 bps hit last week. The spread has widened from under 50 bps since French President Emmanuel Macron called a snap election this month in response to a strong showing for far-right parties in the European Parliament election.

With Marine Le Pen's National Rally leading in the polls but looking set to fall short of an outright majority, the risk of a hung parliament or far-right government has investors worried about France's debt path and fiscal situation. France's 10-year bond yield was up 4 bps at 3.157%. It had spiked as high as 3.338% last week. Bond yields move inversely with prices.

Germany's 10-year bond yield, the euro zone's benchmark, stood at 2.41%, up 2 bps on the day. It is down almost 30 bps from a high of 2.678% reached last week as investors have flocked to the safety of German government debt. "I don't think it's realistic to expect any meaningful tightening of French spreads in the run-up to the election," said Jussi Hiljanen, head of European rates strategy at SEB.

"The spread might be a bit more stable here but still have some underlying widening bias." Danske Bank's fixed income research director, Piet Haines Christiansen, said he did not expect the excessive deficit procedures against France, Italy and others to be a surprise to the market. Yet he said it could get "significant" market attention, given fragile sentiment in France.

Italy's 10-year yield, the benchmark for the euro zone's more indebted countries, was up 5 bps at 3.933%, pushing the spread between Italian and German 10-year yields up 3 bps to 152 bps. On Tuesday, U.S. retail sales grew less than expected, reinforcing expectations that the Fed will begin lowering borrowing costs this year.

The scale of the U.S. economy means global markets, including euro area bonds, and rate cut expectations for the European Central Bank, often move due to shifts in Fed expectations. A significant number of economists polled by Reuters see the ECB cutting its deposit rate twice more this year, in September and December, following June's rate cut.

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