LONDON Southern European government bonds underperformed in a volatile session on Monday as investors mulled the implications for monetary policy of centrist Emmanuel Macron's victory in the French presidential election.
Macron became France's president on Sunday, a result hailed by European leaders as a vote for unity and a blow to political forces that had sought to build on last year's Brexit vote to tear apart the European Union.
The gap between French and German 10-year borrowing costs dropped to 33 basis points at one stage, a six-month low.
But an early rally in low-rated euro zone bond yields dissipated as concerns over what this might mean for the European Central Bank's ultra loose monetary policy stance came to the fore.
"Investors will now go back to the basics of watching the underlying euro zone economic and inflation data and what implications it may have for monetary policy," said Iain Stealey, a fixed income portfolio manager for JP Morgan Asset Management, one of the biggest bond investors in the world.
"The underlying GDP data is too strong for there to be 60 billion euros of (bond) purchases and though inflation numbers are below target, they are not low enough to justify a negative deposit rate," he said, referring to the ECB's bond-buying scheme.
After the first round of the French election, sources on and close to the ECB Governing Council told Reuters many rate-setters saw scope for sending a small signal in June towards reducing monetary stimulus.
Italy was the main underperformer on the day, partly because it has been one of the biggest beneficiaries of the ECB's bond-buying scheme which is weighted towards the size of each member state's economy.
Italy's 10-year government bond yield rose as much as 7 basis points to 2.25 percent, while low-rated equivalents in Spain and Portugal were 2-3 basis higher.
Yields on higher-rated government bonds such as benchmark German Bunds were flat or slightly lower on the day.
Italy is due to hold an election by May 2018, which could coincide with ECB tapering, though, at the margins, investors say there is an outside chance of a snap election before the end of 2017.
Italians are seen as more sceptical about the euro than the French, and the anti-euro 5-Star Movement leads many opinion polls ahead of the ruling Democratic Party.
"Macron's win now means Italian issues won't be obscured by French shadows," said Rabobank strategist Richard McGuire. "And we have the potential twin evils of Italy going to the polls early next year and tapering to think about at the same time."
Citi analysts forecast the Italy-German 10-year bond yield spread - currently at 180 bps - could go as high as 300 bps in the first quarter of 2018.
(Reporting by Abhinav Ramnarayan; Editing by Janet Lawrence and Mark Potter)