Euro zone yields struggle for direction; global risks fail to rattle investors

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Investors continue to price the deposit rate at 2% by end-2026

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Hopes for fiscal stimulus to boost the German economy are fading

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Analysts remain concerned about rising debt levels

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Geopolitical risks fail to move the bond market

By Stefano Rebaudo

Sept 25 (Reuters) - Euro zone government bond yields struggled for direction on Thursday as rates volatility continues to ease with the European Central Bank expected to remain on hold until the end of 2026.

Germany's 10-year yield, the benchmark for the euro zone bloc, dropped half a basis point (bp) to 2.74%, after trading higher earlier in the session.

Markets have recently strengthened their expectations for the European Central Bank to keep rates higher for longer.

Traders priced in a 40% chance of a 25 bps rate cut by July . Still, the key rate is seen at 1.97% in December 2026, compared to 2% currently.

Consumer sentiment in Germany is set to rise slightly heading into October, while remaining in negative territory.

U.S. Treasuries were little changed in London trade with 10-year yields at 4.14%.

Germany's 2-year yields, more sensitive to expectations for European Central Bank policy rates, were flat at 2.02%.

Analysts flagged that investors continued to show limited sensitivity to geopolitical developments, even as Russian incursions into NATO airspace grow bolder and NATO's response becomes increasingly tense.

The drone incursions that shut several Danish airports on Wednesday were a hybrid attack intended to spread fear, Denmark's Justice Minister Peter Hummelgaard said on Thursday.

Markets appear increasingly unfazed by France's ongoing political turmoil, even in the absence of a resolution.

The yield gap between safe-haven Bunds and 10-year French government bonds - a market gauge of the risk premium investors demand to hold French debt - was stable around 81 bps. France's OAT yields fell 0.5 bps at 3.56%.

French unions will hold another day of protests on October 2 to put pressure on new Prime Minister Sebastien Lecornu over their demands to scrap a fiscal austerity programme.

"The current situation is spawning a tension between debt and economic-growth concerns, especially at the long end," said Sebastian Fellechner, analyst at DZ Bank, referring to French political risks and German economic expectations, and this "should keep the Bund yield in check for now."

German business morale unexpectedly declined in September as the economic outlook remained weak.

"Optimism has been grounded, and this is not only due to U.S. tariffs and a stronger euro," said Carsten Brzeski, global head of macro at ING.

"Gone seems to be the hope that the new government and fiscal stimulus would finally lift the economy out of its endless stagnation."

Italy's 10-year yields were up one bp at 3.60%. The yield gap versus safe-haven Bunds was at 85.5 bps, its highest since September 8; it dropped below 80 bps, the lowest since 2010, in mid-August.

The Swiss National Bank held its key interest rate at zero on Thursday, the lowest among major central banks.

(Reporting by Stefano Rebaudo, editing by Ronojoy Mazumdar)