German yields drop with geopolitics in focus, France under the spotlight

By Stefano Rebaudo

Nov 21 (Reuters) - German government bond yields edged lower and spreads widened with markets weighing geopolitical tensions and awaiting purchasing manager surveys (PMI), which could affect expectations for the European Central Bank easing path.

France is in the spotlight as Prime Minister Michel Barnier is facing hurdles to passing the 2025 budget.

Russia launched an intercontinental ballistic missile during an attack on Ukraine on Thursday, Kyiv's air force said, in the first known use in the war of a powerful weapon designed to deliver nuclear strikes thousands of kilometres away.

Germany's 10-year yield, the benchmark for the euro area, was down 1.5 basis points (bps) to 2.32%.

Markets kept pricing in an ECB deposit facility rate at around 1.95% by July while fully discounting a 25-bps rate cut next month and a 20% chance of a 50-bps move.

The prospect of tariff hikes under the new U.S. administration do not shift the inflation outlook in Europe, ECB policymaker Francois Villeroy de Galhau said on Thursday, urging the central bank to keep its options open.

The gap between French and German yields - a gauge of the premium investors demand to hold France's debt - widened 4 bps to 78.5 bps, after hitting 70.9 bps last week, its tightest since Oct. 31.

French 10-year yields rose 2 bps to 3.11%.

Analysts flagged that the debate surrounding France's 2025 budget has been going on for more than a month. If lawmakers cannot agree by mid-December, Barnier can invoke article 49.3 in the constitution to pass the budget without agreement.

That would probably trigger a no-confidence vote that the far-right party Rassemblement National (RN) and the left could use to bring down the government.

RN leader Marine Le Pen on Wednesday threatened to seek to topple Barnier's fragile coalition government if her RN party's cost-of-living concerns were not incorporated into the 2025 budget.

Le Pen also said on Wednesday that the RN would vote for the far-left La France Insoumise (LFI) party's proposal to drop President Emmanuel Macron's pension reform.

According to economists, this reform is crucial to restoring the French debt-to-GDP ratio to a sustainable declining path.

"While France's issues remain constrained to France rather than becoming more systemic, we favour trading it via a French underperformance versus Spain," Lyn Graham-Taylor, senior rates strategist at Rabobank, said.

The yield gap between Spanish and French bonds dropped to -7 bps after trading between 0 and -10 bps since early October.

Italy's 10-year government bond yields, the benchmark for the euro area periphery, rose 1 bp to 3.58%.

The yield spread between Italian and German yields widened 3 bps to 125 bps. It reached 115.90 on Wednesday, its tightest level since mid-March 2024, ahead of a possible upgrade by Moody's on Friday.

"Given the recent improvement in Italy's fundamentals, we have pencilled in a change in rating outlook to positive from Moody's in our forecasts for coming months and potentially this week," Citi said in a research note.

Analysts expect Italy's debt-to-GDP ratio to decline and the country to abide by the European Union's fiscal rules. (Reporting by Stefano Rebaudo, editing by Andrew Heavens)