Euro zone bonds stabilise after bruising week

By Sophie Kiderlin

LONDON, Oct 2 (Reuters) - European government bond markets limped on Friday to the end of a bruising week in which concern about growing fiscal problems and high inflation prompted investors to snap up safe-haven assets such as German and Dutch debt, while sending French borrowing costs to their highest in 14 years.

With France and other heavily indebted countries such as Italy in the crosshairs, German bonds were in high demand, which sent yields on benchmark 10-year Bunds down by as much as 13.7 basis points at one point.

Government bonds around the world have been under pressure recently amid debt and fiscal concerns, high energy prices and worries about inflation.

Trading on Friday remained volatile, particularly for shorter-dated bonds, which tend to be more sensitive to expectations for inflation and interest rates.

German 2-year bond yields were last flat at 3.05%, having swung between session lows of 2.943% and highs of 3.063%, while French 2-year yields were around 4 bps higher at 3.73%, having risen to as much as 3.84% earlier. Italian 2-year yields were down 7 bps at 3.547%.

This week, 2-year German yields have fallen nearly a quarter point, while those on 2-year French bonds have risen nearly 14 bps.

Rene Albrecht, analyst at DZ Bank, flagged a "flight to quality", adding that "the safe haven bid has now arrived".

Data on Friday showed that euro zone inflation rose by more than expected in September, but with the rise in bond yields, which effectively creates tighter credit conditions, traders pared back their bets on interest rate hikes from the ECB. A further policy increase from the central bank is now not being fully priced in by traders until early 2027.

Inflation in the 21 nations that share the euro jumped to 3.8% in September from 3.2% a month earlier, exceeding expectations for 3.6% in a Reuters poll, driven primarily by fuel, natural gas and, to a lesser extent, food costs.

A closely watched "core" figure, which excludes volatile food and fuel prices and signals underlying trends, accelerated to 2.5% from 2.4%.

DZ Bank's Albrecht said that the core reading showed that the underlying inflation trend was "actually quite steady and given the circumstances quite okay."

FRANCE IN FOCUS

Ten-year government bond yields showed a similar divergence on Friday. German 10-year bond yields were last down 6 bps at 3.456%, set for a weekly drop of 17 bps, while Italian 10-year yields were down 11 bps on the day at 4.609% but up 6 bps for the week.

French 10-year yields , meanwhile, were down 9 bps on the day at 4.844%, having almost hit 5% for the first time in nearly 25 years. This week, 10-year French yields have risen 12 bps.

This has left the premium of French yields over German – a measure of the extra compensation investors demand for lending to France – around 140 bps, having earlier surged to almost 160 bps for the first time since late 2011.

French bonds have been under especially intense pressure as high debt levels and emerging political risks ahead of a 2027 presidential election have added to factors weighing on government bonds more broadly, such as expectations for higher policy rates.

"When risk tone turns, investors tend to become fickle about the risk premia they require to keep holding positions," George Adcock Rodriguez, co-portfolio manager at 36 South Capital Advisors, said.

France on Thursday presented its 2027 budget bill, seeking to enact unpopular belt-tightening measures to lower its deficit, but this gave markets little relief.