By Alun John

Euro zone bond yields held steady on Monday and, with little scope for dramatic changes in ECB policy expectations, investors' focus was shifting to whether longer-dated bonds would underperform short-dated ones or if any particular market would diverge from its peers.

Germany's 10-year yield, the euro zone benchmark, touched 2.94%, its highest level since June 23 and little changed on the day. (DE10YT=RR)

It rose by 8 basis points last week, influenced by a move higher in U.S. and Japanese yields and as traders' attention shifted to the longer-term borrowing outlook in both Europe and more broadly.

Germany's cabinet was set to approve the first draft of the 2027 budget on Monday, with total borrowing of €203.6 billion ($232.8 billion), up from the €196.5 billion signalled in April.

Still, despite this greater borrowing, the 10-year Bund yield is well below its mid-May high of 3.2%, which was notched when the Strait of Hormuz was effectively closed, oil prices were elevated and investors were bracing for a stagflationary shock in Europe that would force the European Central Bank to hike rates significantly despite slowing growth.

ECB BETS STEADY

Markets now see one further 25-bp ECB rate hike this year as likely, if not certain, on top of last month's move.

However, a third move is off the table, particularly after last week's softer-than-expected inflation data.

That development has kept short-dated yields in check. The German 2-year yield was at 2.54% on Monday, flat on the day, and having been broadly steady for the past 10 days.

With less scope for trading around ECB policy, traders were looking elsewhere.

"Traded inflation's continued decline in Europe reinforces a narrow channel for front-end core yields," Goldman Sachs analysts said in a note.

They added that, as bonds' volatility would likely remain low, investors would be looking for higher yields for longer-dated bonds or other euro zone markets.

The gap between Germany's 2- and 10-year yields hit its highest in a month last week, and was last at 40 bps. (DE2DE10=RR)

EYES ON FRANCE

Other euro zone yields were moving roughly in line with the benchmark on Monday. Italy's 10-year yield was flat at 3.71%. France's was steady at 3.72%, though its bonds have underperformed recently. (FR10YT=RR), TVC:IT10Y

The gap between the French and German yields is back at near 80 bps, its highest since November last year. France's yield has also ticked back above Italy's, as investors worry about France's gridlocked parliament and its high debt levels.

"We remain bearish on France due to political risk," Nomura analysts said, noting they expected French yields to rise further above Italian and Spanish ones.

France will hold a presidential election next year, and the French Appeals Court is set to rule on whether far-right leader Marine Le Pen can stand as a candidate in that election.

"The real problem in France, however," the Nomura analysts said, "is that any new president is likely to call immediate snap legislative elections and face the same level of fragmentation as currently, which will make it very challenging to implement the necessary structural reforms to grow the economy and the difficult choices to reduce France's large primary deficit."