Bund yields tick up as investors weigh German election result, ECB decision

Euro zone government borrowing costs edged higher on Monday, with investors weighing the outcome of a key German state election against the backdrop of an upcoming European Central Bank (ECB) meeting.

The yield on Germany's 10-year Bund, a benchmark for the region, rose 1.5 basis points to 3.35%. This follows two days of declines from its highest level in over 15 years, which was touched last week. The move came as the far-right Alternative for Germany (AfD) secured a significant victory in the Saxony-Anhalt state election, winning 44% of the vote and delivering a heavy blow to Chancellor Friedrich Merz's conservative bloc.

Analysts, however, suggested the direct market impact of the regional result could be limited. "The impact on Bunds or Länder bonds looks set to be marginal," said Rainer Guntermann, a strategist at Commerzbank. He noted that any effect could be negative, as internal friction within the federal government following the poor performance of the CDU and SPD might complicate the implementation of reform plans for the remainder of the year.

Attention is now firmly fixed on the ECB's policy meeting scheduled for Thursday. The central bank is widely expected to raise interest rates, opting for caution as elevated energy prices and resilient economic growth keep inflationary pressures alive. The conflict involving the U.S. and Iran continues to support oil prices, adding to these concerns.

Adding to the inflation calculus, natural gas prices remain a key focus. The benchmark Dutch front-month contract at the TTF hub rose by 2.82 euros to 74.40 euros per megawatt hour (MWh), after reaching its highest level since January 2023. The increase follows attacks on oil tankers, which have further dimmed hopes of reviving Qatari liquefied natural gas (LNG) flows from the region.

Market pricing indicates a strong probability of a second rate hike following the expected move this month. Traders were pricing the ECB's deposit rate at 2.71% by December, implying more than an 80% chance of another increase from the current 2.25%. Analysts at Amundi Investment Institute suggest the central bank may pause after September but are watching for renewed upside risks from gas and food prices that could make inflation more entrenched.

In the periphery, Italy's 10-year government bond yield rose 3.5 basis points to 4.18%, keeping the yield gap over safer German Bunds at 80.50 basis points.