Bund yields hit 5-1/2-week high, markets eye US rates, German politics

By Stefano Rebaudo

Dec 27 (Reuters) - Euro area benchmark Bund yields hit their highest levels in more than five weeks in thin holiday trading on Friday, with investors watching moves in U.S. Treasuries.

Yields were on track for a yearly rise as markets expect higher-for-longer interest rates on both sides of the Atlantic after strong U.S. data and expectations for inflationary policies from President-elect Donald Trump.

The benchmark U.S. Treasury note yield rose on Friday after paring its gains a day earlier in the wake of a strong seven-year note auction.

Euro area borrowing costs had increased on Monday before the Christmas break, although European Central Bank President Christine Lagarde said the euro zone was getting "very close" to reaching the central bank's medium-term inflation goal.

Germany's 10-year bond yield, the benchmark for the euro zone bloc, was up 8 bps at 2.404%, its highest since Nov. 18. It was on track to end 2024 with a 36 bps increase.

"Bunds are close to their fair value but in 2025 they will be more driven by fiscal policy (in Germany) as more bond supply can increase their yields," said Gregoire Pesques, chief investment officer of global fixed income at Amundi.

"However, it will depend on the balance between fiscal spending and investments," he added. "For bund valuations, more investments that support the economy will be seen as more positive than just (fiscal) spending."

Germany will hold a general election in February 2025, with investors wondering whether a new government will allow higher public borrowing to prop up the flagging economy.

Germany's two-year yield, more sensitive to expectations for ECB policy rates, rose 4 bps to 2.11% and was on track for a 29-bps yearly fall.

Money markets are pricing in a European Central Bank deposit facility rate of 1.97% in July 2025, roughly in line with levels seen last week.

Italy's 10-year yield, the benchmark for the euro area periphery, rose 8 bps to 3.582%, its highest since Nov. 22, with the yield gap between BTPs and Bunds little changed at 116 bps.

"We are still overweight in the so-called peripheral countries such as Greece, Italy and Spain as their economies are doing well while maintaining fiscal discipline," Amundi's Pesques said.

French politics remained in the spotlight, with investors trying to assess whether a new government there can tackle the country's fiscal problems.

The yield spread between French government bonds and safe-haven Bunds - a gauge of the risk premium investors demand to hold French debt - rose slightly to 81 bps. It recently hit its highest in more than 12 years at around 90 bps on worries that the new government will not be able to curb a rising fiscal deficit.

Russian President Vladimir Putin said on Thursday that Moscow was open to hosting peace talks with Ukraine, while Russia's arms control point man warned Trump's incoming administration against resuming nuclear testing, saying Moscow would keep its own options open. (Reporting by Stefano Rebaudo, Editing by Hugh Lawson)