April 18, 2017 / 10:43 AM / 4 months ago

UPDATE 2-Euro zone bond markets set sights on French presidential election

* First round of voting in French elections on Sunday

* One of country's most unpredictable election in decades

* French/German 10-year yield gap tightest in a week

* UK PM calls early election in June

* Euro zone periphery govt bond yields tmsnrt.rs/2ii2Bqr (Updates prices)

By Dhara Ranasinghe

LONDON, April 18 (Reuters) - The premium investors demand for holding French government bonds over German peers tightened to a one-week low on Tuesday after a poll gave centrist independent Emmanuel Macron the lead ahead of the first round of France's presidential election.

Also highlighting the market impact of political risk in Europe, Britain's Prime Minister Theresa May on Tuesday called for an early election in June - pushing British gilt yields lower and adding to downward pressure on safe-haven Bund yields.

But for euro zone bond markets, the main focus remained Sunday's vote in France, with shifts in expectations making for a volatile trading mood.

"Every poll that is coming out now is being scrutinised closely," said DZ Bank strategist Christian Lenk. "Markets remain very nervous ahead of Sunday."

An Ifop-Fiducial poll on Tuesday showed Macron taking 23 percent of the first round vote, with far-right anti-euro candidate Marine Le Pen on 22.5 percent. Conservative Francois Fillon and far-left candidate Jean-Luc Melenchon were both on 19.5 percent.

A surge in support for Melenchon in recent weeks has unnerved markets.

France's 10-year government bond yield reversed early rises to trade flat on the day at 0.90 percent.

The gap over German peers tightened briefly to around 70 basis points, its lowest in about a week and down from six-week highs hit last week around 78 bps.

Germany's benchmark 10-year Bund yield was marginally lower at 0.175 percent, trading in line with most other higher-rated euro zone government bonds.

COUNTDOWN

Opinion polls indicate the election in the euro zone's second biggest economy will come down to a May 7 run-off between Macron and Le Pen, head of the anti-European Union and anti-immigrant National Front.

But the race has tightened and the margin of error in some recent polls shows any two of the four top candidates could qualify.

That uncertainty means any recovery in French bonds could be short-lived.

"(Euro zone bond) investors are going to be very careful this week and clearly the only thing that's going to be on their minds is what happens in France," said Chris Scicluna, head of economic research at Daiwa Capital Markets.

"Macron will win if he can get through to the second round but the question is whether he will actually get there."

France's presidential race, one of the most unpredictable in decades, is viewed as a key risk event for markets wrongfooted last year by the Brexit vote and the election of U.S. President Donald Trump.

The jitters are also reflected in currency markets, where the cost of hedging against volatility in the euro over the next month against both the dollar and yen on Monday jumped to the highest levels since Britain voted to leave the EU last June .

Liquidity in general across euro zone bond markets was thin as traders returned from the Easter break and reacted to the recent French poll results.

For Reuters Live Markets blog on European and UK stock markets see reuters://realtime/verb=Open/url=http://emea1.apps.cp.extranet.thomsonreuters.biz/cms/?pageId=livemarkets

Editing by Jeremy Gaunt and John Stonestreet

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