Euro zone government bond yields fall on US-China tariff jitters, French relief rally

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French debt risk premium declines further after proposal to suspend pension reform

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Citi warns that snap elections may still be on the horizon

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German Bund yields fall amid concerns over US-China trade tensions

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Traders price in a 70% chance of a European Central Bank rate cut by summer

(Recasts paragraph 1, adds background)

By Stefano Rebaudo and Amanda Cooper

LONDON, Oct 15 (Reuters) - Euro zone borrowing costs fell on Wednesday, driven by a relief rally in French government bonds and renewed concerns over the economic fallout from U.S.-China trade tensions. By shelving pension reform until after 2027 and appeasing leftist lawmakers who fiercely opposed the overhaul, French Prime Minister Sebastien Lecornu has managed to stave off a sharp escalation in France's prolonged political crisis.

French 10-year yields fell 7 basis points to 3.334%, the lowest since August 14, bringing the decline so far this week to over 10 bps, heading for the largest weekly decline since May. "This averts the event risk (snap elections) for now and might result in further OAT tightening towards 75 bps," said Aman Bansal, senior European rate strategist at Citi, referring to the French 10-year yield's premium to its German counterpart.

"However, this also indicates the rising cost of propping up the minority government which might eventually give way to a snap legislative election into the March 2026 municipal election anyway," he added.

ECB RATE CUT BETS INCREASE

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 at 77.50 basis points. It hit 87.96 bps early last week, the highest since January 13 on concerns about the French fiscal outlook.

"The proposed 2026 draft budget would aim for a 4.7% deficit of GDP, which is broadly in line with the previous outlook, and without the pension reform puts the trajectory of deficit/GDP closer to 5.0% over time," Jim Reid, a strategist at Deutsche Bank, said.

"So even though that might read negatively from a debt sustainability point of view, markets were reassured because it was seen as raising the chances that Lecornu would remain as PM and a snap legislative election would be avoided."

France's borrowing costs are among the highest in the euro zone as investors have grown increasingly wary of holding its sovereign debt given the fragility of the government's finances. Meanwhile, German 10-year yields were down 4.5 bps on the day at 2.56% - the lowest since July 7 - having dropped this week after mounting trade tensions between the U.S. and China. U.S. Treasury Secretary Scott Bessent on Wednesday insisted that Washington did not want to escalate a trade conflict with China, stressing that President Donald Trump was ready to meet Chinese President Xi Jinping in South Korea later this month.

However, concerns about the economic impact of a potential trade war between the U.S. and China recently prompted investors to boost their bets on future European Central Bank rate cuts.

Money markets priced in about a 70% chance of a 25-basis-point ECB rate cut by July. The ECB key rate is seen at 1.83% in December 2026 down from around 2% before U.S. President Donald Trump threatened higher tariffs against China. The depo rate is currently at 2%. (Reporting by Stefano Rebaudo and Amanda Cooper. Editing by Alexandra Hudson and Mark Potter)