German 10-year yield hits one-month high on political uncertainty

 Germany's 10-year bond yield rose to a one-month high on Monday after the results of two German state elections dealt a blow to the ruling coalition, while investors also remained focused on monetary policy expectations and increasing bond supply.

The Alternative for Germany (AfD) was the big winner in the elections, looking set to secure over 33% of the vote in Thuringia, becoming the first far-right party to win a regional election in Germany since World War Two.

The results are set to increase the pressure on the ruling coalition government, led by Chancellor Olaf Scholz's Social Democrat Party.

A faltering German government could complicate European policy, with France still struggling to form a government after legislative elections in June and July.

"Things aren't looking good in either of the two largest economies of the euro area," said Chris Scicluna, head of economic research at Daiwa Capital Markets.

"The core of the euro area is looking very weak politically and the rise of the far-right and far-left is going to undermine the confidence of investors, particularly investors located beyond the euro area."

Germany's 10-year bond yield DE10YT=RR, the bloc's benchmark, rose as high as 2.349%, its highest level since July 30. It was last up 4.5 basis points (bps) to 2.335%. Bond yields move inversely with prices.

Others played down the longer-term impact of the German election results, suggesting the governing coalition would likely continue in power until the federal election next year.

"Domestic political headlines after the disappointing results for the federal government's coalition parties in the regional elections probably won't have a lasting impact," said Commerzbank rates strategist Rainer Guntermann.

"While the election results could further exacerbate the conflicts within the coalition and within the coalition parties, a break-up of the coalition and new elections are unlikely."

Investors were also monitoring European Central Bank (ECB) policy expectations, with futures implying around a near 100% chance of a quarter-point rate cut at the September meeting.

ECB policymakers are increasingly at odds on the outlook for growth, Reuters reported on Monday citing sources, a rift that could shape the rate cut debate for months.

Germany's two-year yield DE2YT=RR, which is sensitive to changes in interest rate expectations, rose 3.1 bps to 2.42%.

Meanwhile, euro zone bond supply is set to pick up this week after a summer pause, which could also weigh on bond prices, analysts said.

"It (higher bond supply) can have a very short-term impact," Daiwa's Scicluna said. "I do think it's one of those factors that is going to be contributing to yields being higher-for-longer over the medium to longer term."

France, Spain, Germany and Austria are all expected to issue bonds this week worth a total of 25 billion euros. In addition, Italy might launch a syndicated transaction at the extra-long end of the curve, UniCredit fixed income strategists said in a note.

Italy's 10-year bond yield IT10YT=RR rose 1 bp to 3.703%, pushing the yield gap between German and Italian 10-year bonds to 136 bps.