Euro zone yields dip as activity stalls; concern bubbles over France
Updates throughout; refreshes prices at 1525 GMT
By Stefano Rebaudo and Amanda Cooper
July 24 (Reuters) -Short-dated euro zone yields dipped on Wednesday after a survey showed business activity in the region stalled in July, prompting investors to up the chances of two more rate cuts from the European Central Bank this year.
Investor concern about France has also picked up this week, which has weighed on the country's bonds and pushed up the cost of insuring its sovereign debt against default.
Growth in euro zone business activity stalled this month as a tepid expansion in the bloc's dominant services industry failed to offset a deeper downturn among manufacturers, a survey showed on Wednesday.
HCOB's preliminary composite Purchasing Managers' Index, compiled by S&P Global, dropped to 50.1 this month from June's 50.9, barely above the 50 mark separating growth from contraction and defying expectations in a Reuters poll for an uptick to 51.1.
A German survey earlier showed activity in the euro zone's largest economy shrank unexpectedly this month, adding to the sense that the European Central Bank is highly likely to cut interest rates when it meets in September.
German two-year yields DE2YT=RR, which are more responsive to the interest rate outlook, fell 5.4 basis points (bps) to 2.713%.
The yield on the 10-year Bund DE10YT=RR, the benchmark for the euro zone, was flat at 2.441%. It traded at 2.46% last week before U.S. President Joe Biden abandoned his reelection bid, which sent ripples through markets.
Money markets showed traders raised their bets on future rate cuts by the ECB, with a 92% chance of two cuts by year-end, from less than 80% before the PMI data. EURESTECBM3X4=ICAP
FRENCH RISK
Meanwhile, the premium investors demand to hold French bonds rather than German Bunds DE10FR10=RR rose to 71.70 bps, the highest since France's inconclusive election earlier this month, before retreating to 70.8 bps.
Citi analysts flagged in their morning note that the far-left La France Insoumise's (LFI) proposal to reverse President Emmanuel Macron's pension reform with support from the far-right Rassemblement National (RN) triggered a widening gap between French and German government bond yields.
"Our economists' base case remains for a 'truce' government, which is unlikely to propose meaningful legislations like this," Citi rate strategists said.
"Further, it is not clear whether left parties other than the LFI, whose support is needed to pass the bill, would want to join hands with the RN for this purpose."
Macron said on Tuesday his outgoing government would remain in place until mid-August while France hosted the Olympic Games, dismissing an effort by a left-wing alliance to name a prime minister.
Investors feared a new government led by the far right or the far left could increase fiscal spending, increasing the risk premium of France's public debt.
Moreover, French credit default swaps (CDS) - a derivative that compensates a bondholder in the event of a sovereign or corporate debt default - are trading at 30 bps FRGV5YUSAC=MG, their highest in a month.
At the height of the angst over France's political future in late June, French five-year CDS hit a four-year high of 36 bps
Italian 10-year yields IT10YT=RR rose 4 bps to 3.795%, pushing the gap between Italian and German Bund yields DE10IT10=RR 5 bps wider to 135.3 bps.
This spread hit 120 bps last week, a level not seen since before Macron's decision to call a snap election, sending jitters across financial markets.
Political risk has affected markets more acutely of late. In the United States, investors are also closely watching developments in the election campaign as Vice President Kamala Harris is expected to be the Democratic Party's candidate to face Republican Donald Trump.
The prospect of a Trump win, perceived to be bullish for equities, has weighed on longer-dated U.S. Treasuries, given the chances of a big increase in spending that could undermine the country's fiscal position.
Antonio Cavarero, head of investments at Generali Asset Management, believes this could favour euro zone government bonds.
"Given this backdrop, the view remains favorable towards government bond investments, particularly in Europe, where the monetary policy path seems clearly outlined," Cavarero said.
Reporting by Stefano Rebaudo; Editing by Toby Chopra and Mark Potter
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