Bund yields drop with oil, shrug off German vote, but Merz under scrutiny

By Stefano Rebaudo

Sept 21 (Reuters) - Euro area benchmark Bund yields dropped on Monday, tracking moves in oil prices and showing a muted reaction to gains by the far-right Alternative for Germany (AfD) and a far-left party in regional elections.

German Chancellor Friedrich Merz vowed to accelerate reforms to move Germany forward after the far-left Left Party won the Berlin state election and the AfD was projected to win the most votes in the state of Mecklenburg-Western Pomerania.

Oil prices slid to their lowest in more than a week on Monday on hopes diplomacy in the Iran war will get a chance this week amid a UN meet, and as investors eyed a partial recovery in shipments from Saudi Arabia despite ongoing attacks by Yemen's Houthis.

The AfD's growing popularity could have pressured Bunds if increased frictions within the federal government following weak CDU results hindered the passage of reforms, clouding Germany's fiscal and economic outlook, analysts said.

However, market participants still expect the current government to continue its policy agenda.

"After a potentially contentious debate, the coalition will likely soften some of the envisaged entitlement cuts, for instance with a long transition period for the end of early retirement," Holger Schmieding, chief economist at Berenberg, said.

"Nonetheless, I still expect the coalition to implement the bulk of its planned pro-growth reforms."

German 10-year Bund yields DE10YT=RR were down 5 basis points at 3.48%, virtually wiping out Friday's rise.

"Our base case remains that Merz survives, but the leadership meetings this week will be closely watched by markets looking for signs of further political instability at the core of Europe," Evelyne Gomez-Liechti, multi-asset strategist at Mizuho, said.

FRENCH AND ITALIAN BONDS REBOUND

French and Italian government bonds rebounded after Monday's selloff, which was triggered by expectations of a steeper path for policy rates, a prospect that would increase borrowing costs for the euro area's heavily indebted countries.

France's OAT yields FR10YT=RR were down 6 bps at 4.50%, while Italy's BTP yields TI10YT=RR fell 6.5 bps to 4.37%. They rose by 12.5 bps and 10 bps, respectively, on Friday.

France's debt is expected to reach a record high of 119.3% of output in 2026, with a projected debt-to-GDP ratio of 121.7% in 2027, the finance ministry said on Saturday.

Italy has kept its budget deficit largely under control in recent years, but its debt burden remains high, with the European Commission forecasting public debt to rise to 138.5% of GDP in 2026 from 137.1% in 2025.

Money markets priced in a European Central Bank deposit rate of 3.40% by late 2027 EURESTECBM9X10=ICAP, up from the current 2.50%, and at 2.87% by end-2026, implying one hike and about a 50% chance of a second move.

(reporting by Stefano Rebaudo; Editing by Jan Harvey)

((stefano.rebaudo@tr.com))