UPDATE 1-Euro zone yields edge lower, Italian bonds outperform

Euro zone government bonds slipped on Monday in a week packed with macro events, including rate decisions from the Federal Reserve, Bank of Japan and Bank of England, which could influence investor appetite for euro zone debt. French bonds traded roughly in line with their German peers, after lagging in early trade as credit ratings agency Fitch cut France's long-term rating on Friday.

Borrowing costs rose on Friday after the European Central Bank maintained an upbeat view on growth and inflation. Germany's 10-year yield, the benchmark for the euro zone bloc, fell 1.5 basis points (bps) to 2.70%.

Markets priced in a 40% chance of a 25 bps ECB cut by June 2026 to 1.75%, and a depo rate at around 1.95% in December 2026. Some analysts remain cautious about market pricing for the ECB rate outlook, warning that expectations may be running ahead of fundamentals.

"(ECB President Christine) Lagarde sounded a bit hawkish last week, backing a higher-for-longer rate scenario," said Gabriele Foa, portfolio manager at Algebris Investments. "Still, we expect possible ECB easing next year, especially after the Fed starts cutting rates and markets begin to feel the drag from U.S. tariffs and a strong euro."

Germany's 2-year yields, more sensitive to expectations for European Central Bank policy rates, rose 1.5 bps to 2.00%. Italian sovereign bonds outperformed their peers with the 10-year yield dropping 4 bps to 3.51%.

"Monthly fiscal data through the summer suggest this year's budget deficit may again be smaller than envisaged," said Giada Gianci, an economist at Citi, mentioning Monday's figures released by the Bank of Italy. "BTP holdings of foreign investors jumped higher again in June, but their share of total outstanding debt is still low by historical and international standards," she added.

The focus is now shifting to the Fed policy meeting outcome due on Wednesday. "A more political Fed in 2026, perhaps being comfortable with inflation running slightly warmer than 2%, could bring a fairly low bar for cuts to 2–2.5% in most positive economic states of the world," said Jason Williams strategist at Citi.

Markets are currently fully pricing a 25 bps Fed rate cut this week and 145 bps by end 2026, from the current level of between 4.25% and 4.50%. France's OAT yields fell 1.5 bps to 3.49%.

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 79 bps. Some analysts flagged that OATs are already trading markedly cheaper than double-A or single-A rated peers.

The premium investors demand to own French, rather than German bonds, traded above 80 bps on Monday, having risen from around 65 bps in the last month, as a vulnerable French government headed towards last week's confidence vote. "If France falls below AA- from two or more rating agencies, we could see some forced selling from institutional accounts," said Jefferies strategist Mohit Kumar.

President Emmanuel Macron last week named loyalist Sebastien Lecornu as prime minister, after predecessor Francois Bayrou was toppled in the parliamentary confidence vote over the government's hugely unpopular budget.

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