Germany's Economic Dip Drives Euro Zone Yield Drop Amid Political Uncertainties

Euro zone yields fell following a report that German business activity unexpectedly contracted in July. This led to increased speculation of European Central Bank rate cuts. Investors are also closely monitoring the U.S. election campaign and developments in France and Italy impacting government bond yields.

Euro zone yields fell after a survey showed German business activity unexpectedly contracted in July, leading investors to increase slightly their bets for two European Central Bank rate cuts by year-end.

The HCOB German flash composite Purchasing Managers' Index fell to 48.7 in July, while growth in euro zone business activity stalled. Investors are also closely watching developments in the U.S. election campaign as Vice President Kamala Harris is expected to be the Democratic Party's candidate to face Republican Donald Trump.

Germany's 10-year bond yield, the benchmark for the euro zone bloc, dropped 2.5 basis points (bps) to 2.41%. It was at 2.46% before Joe Biden abandoned his reelection bid. Money markets increased their bets on future rate cuts, pricing in a 90% chance of two ECB moves by year-end from less than 80% before the PMI data.

Meanwhile, the yield gap between Bunds and OATs - a gauge of the risk premium investors demand to hold French government bonds – hit a fresh post-election high of 71.70 bps. Citi analysts flagged in the morning note that the far-left La France Insoumise's (LFI) proposal to reverse President Emmanuel Macron's pension reform with support from the far-right Rassemblement National (RN) triggered a widening gap between French and German government bond yields.

"Our economists' base case remains for a 'truce' government, which is unlikely to propose meaningful legislations like this," Citi rate strategists said. "Further, it is not clear whether left parties other than the LFI, whose support is needed to pass the bill, would want to join hands with the RN for this purpose."

Macron said on Tuesday that his outgoing government would remain in place until mid-August while France hosted the Olympic Games, dismissing an effort by a left-wing alliance to name a prime minister. Markets feared that a new government led by the far right or the far left could increase fiscal spending, increasing the risk premium of France's public debt.

Italy's 10-year yield was higher by 1.5 bps at 3.77%, and the gap between Italian and German bund yields widened slightly to 135 bps. It hit 120 bps last week, a level not seen since before Macron called for snap elections, sending jitters across financial markets.

(With inputs from agencies.)