LONDON: Election relief spread across French government bond markets on Monday, bringing with it pain for Europe's benchmark German debt as focus shifted to the prospect of sooner-than-expected monetary tightening from the European Central Bank.
As French yields fell to multi-month lows, the premium investors demand to hold the debt over German peers shrank sharply after centrist Emmanuel Macron won the first round of France's presidential race. The result also lifted the euro and European stocks.
That sparked an unwinding of safe-haven bets and, as investors started to factor in rising expectations for an ECB rate hike in early 2018, the German two-year yield was on track for its biggest daily jump since December 2015.
Final voting figures for Sunday's first-round vote from France's Interior Ministry put Macron on 23.75 percent and the far-right, anti-EU Marine Le Pen on 21.53 percent.
The result was seen as one of the most market-friendly outcomes, lessening the risk of an anti-establishment shock on the scale of Britain's vote to quit the European Union with Macron well ahead in opinion polls for the final vote on May 7.
A survey by Opinionway on Monday showed Macron beating Le Pen in the run-off by 61 percent to 39 percent.
French 10-year bond yields slid over 10 basis points to more than three-month lows at 0.74 percent, while the yield on Germany's safe-haven 10-year Bund yield jumped over 10 basis points to a one-month high at 0.37 percent.
That left the gap between the two, a barometer in recent months of French election risks, at its tightest since December at around 40 bps and down from around 62 bps on Friday.
The French/German two-year bond spread halved from where it stood late on Friday to around 20 bps.
"The spread has tightened so much because Macron is through to the second round and the opinion polls were accurate, so markets can take comfort from the projections that Macron will win the presidency in the second round," said Peter Chatwell, head of rates strategy at Mizuho.
Worries about the popularity of anti-euro Le Pen had alarmed investors and fanned concerns about euro zone stability.
The Italian/German 10-year yield spread, which stood at just over 200 bps last week, fell to around 180 bps -- its tightest level since early March.
Borrowing costs in southern Europe tumbled 8-13 bps, lead by Portugal. On Friday, Portugal retained its investment grade status with ratings agency DBRS, ensuring that the country will continue to benefit from the ECB's bond-buying stimulus.
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But there was sharp selling in shorter-dated German bonds as investors bet that falling political risks and a brighter economic outlook could encourage the ECB to wind down its economic stimulus programme sooner rather than later.
Germany's two-year bond yield jumped more than 10 basis points to three-month highs at minus 0.68 percent. It was set for its biggest one-day rise since December 2015.
While the ECB is not expected to deliver any significant changes when it meets on Thursday, money markets also moved to price in a higher chance of a rate rise early next year following the French election results.
"While this week's meeting will be pretty boring because the ECB does not want to pre-empt the presidential election outcome, the market will likely start to look ahead to the June meeting pretty quickly," said Patrick O'Donnell, an investment manager at Aberdeen Asset Management.
The ECB could in June remove its downward bias to deposit rate guidance, he said.
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