Euro zone yields edge up before inflation data, caution over France

FILE PHOTO: A view of the European Central Bank (ECB) headquarters in Frankfurt, Germany March 16, 2023. REUTERS/Heiko Becker//File Photo

By Stefano Rebaudo

(Reuters) - Euro zone government bond yields edged up on Wednesday as investors awaited inflation data from the U.S. and some members of the bloc on Friday, and the first round of a French legislative election during the weekend.

The French debt risk premium remained within striking distance of its seven-year high, hit almost two weeks ago on fears of a budgetary crisis at the heart of Europe.

A new French government led by Marine Le Pen's far-right National Rally (RN) would end the decades-long practice of running high budget deficits and stick to the European Union's fiscal rules, the party's financial pointman told Reuters.

German 10-year bond yield, the benchmark for the euro area, rose 2 basis points (bps) to 2.43%.

France, Italy and Spain will release inflation data on Friday, while the German and euro area figures are due next week. Investors are also looking to Friday's release of the U.S. personal consumption expenditures (PCE) price index - the Federal Reserve's preferred gauge of inflation.

Money markets priced in cumulative 68 bps of European Central Bank monetary easing this year, implying an additional 25 bps rate cut and a 70% chance of a third move in 2024.

Data continues to suggest that price growth will settle at the European Central Bank's 2% target, Finnish ECB policymaker Olli Rehn said on Wednesday.

However, market concerns about inflation increased after data from Canada showed an unexpected turn creating some jitters among U.S. debt investors.

Australian inflation accelerated to a six-month high in May, catching traders off-guard and prompting markets to raise the chances of another interest rate hike this year.

The gap between French and German 10-year yields - a gauge of risk premium investors demand to hold French government bonds – was at 72 bps. It hit its highest level since February 2017 at around 82 bps the day after president Emanuel Macron called a snap election.

"If National Rally wins a relative majority, we likely see tightening in French government bond (yield spreads)," said Gordon Shannon, partner and portfolio manager at TwentyFour Asset Management, arguing that Le Pen has made the right noises about working with Macron's government "so the market won't jump straight to pricing in a fiscal crisis".

"However, I also see a widening in the medium term as political leaders less committed to European integration would weaken the EU and the ECB's ability to respond to external shocks," he added.

Market participants see as unlikely a new French government led by the far left New Popular Front (NFP), which they expect would trigger a further widening of French yield spreads.

Italy's 10-year government bond yield was up 0.5 bps at 3.94%, while the Italian-German yield gap stood at 150 bps.

(Reporting by Stefano Rebaudo, editing by Alex Richardson)