Euro area yields hit multi-week highs, spreads widen

 Euro zone government bond yields hit multi-week highs and spreads widened on Tuesday as investors worried about the risk that geopolitical tensions in the Middle East could boost inflation expectations.

Markets were also closely watching political developments in France, which, along with Italy and other countries under the EU’s Excessive Deficit Procedure (EDP), will have to submit draft budgetary plans to the European Commission.

The EDP is designed to ensure that EU countries correct excessive deficit and debt levels.

The price of crude oil, one of the main drivers of consumer prices, dropped after surging more than 7% in the previous three sessions on supply concerns prompted by fears of widening Middle East conflict and a shutdown of some Libyan oilfields.

Germany's 10-year government bond yield DE10YT=RR, the benchmark for the euro zone, was up 3 basis points (bps) at 2.281%, after hitting 2.3%, its highest since Aug. 1.

French President Emmanuel Macron appeared to be back to square one in consultations to form a new government as Socialists and Greens said they would not participate in further talks.

Macron thinks the balance of power lies more with the centre or centre-right. But any such alliance would also require driving a wedge through the left to win backing from its more moderate factions, something leftist leaders have repeatedly ruled out.

"The default option (without a new government) would mean a budget drawn up by the caretaker prime minister Gabriel Attal," said Edmond de Rothschild Asset Management.

"Ten billion euros in cost-cutting is planned, but that would be less than expected by Brussels in its excessive deficit procedure against France."

Parliamentary approval of the 2025 budget is one of many tests at a time when France is under pressure from the European Commission and bond markets to reduce its deficit.

The yield gap between French and German government bonds DE10FR10=RR - a market gauge of the risk premium investors demand to hold France's public debt - widened to 73 bps. It hit 88 bps in early August, its highest since 2012, and reached 85 bps during French elections.

Italy's 10-year yield IT10YT=RR, the benchmark for the euro area periphery, was last up 7 bps at 3.666%. It earlier hit its highest since Aug. 8 at 3.686%.

The yield gap between Italian and German bond yields DE10IT10=RR widened 3 bps to 138 bps.

Investors also await the release of the bloc's August inflation data later in the week, which could provide clues about the European Central Bank's monetary policy path.

"The headline (inflation) rate is expected to tick lower on declining petrol prices," ING analysts said in a research note.

"If that indeed plays out, don't expect it to have too much of an impact on the next (ECB) rate decision."