(Nov 7): Inflation concerns and worries about increasing Bund supply after the government collapse in Germany triggered a sharp rise in euro area yields and led Germany's 10-year swap spread to hit its lowest level more than 20 years.

Analysts expect new US policies after Donald Trump was elected president to result in more inflation as additional tariffs raise prices for consumers and businesses, which will also affect the eurozone.

German Chancellor Olaf Scholz sacked his finance minister Christian Lindner on Wednesday and paved the way for a snap election, triggering political chaos in Europe's largest economy hours after Donald Trump won the US presidential election.

Germany's 10-year yield DE10YT=RR, the euro area's benchmark, rose nine basis points (bps)to 2.48%, after hitting 2.498%, its highest since mid-July.

The selloff in German assets was in line with their peers as yields in French OATs FR10YT=RR, Italian BTPs IT10YT=RR and Spanish Bonos ES10YT=RR rose about 9bps to 3.25%, 3.81% and 3.23% respectively, leaving spreads roughly unchanged.

Investors worry about uncertainty over the budget and a possible increase of government bonds supply.

"The quantitative tightening of the ECB [European Central bank] and fears of increasing supply due to the political crisis in Germany triggered the recent moves in the asset swap spread [ASW], which dropped in the negative territory in 10y tenors," said Hauke Siemssen, rate strategist at Commerzbank.

Germany's 10-year ASW was last down 6bps at -5bps after hitting -6.70bps, its lowest level on record.

It was at around 23bps in early October and at about 50bps at the end of 2023.

Swap spreads, the difference between the 10-year yield and the 10-year swap rate, can be a reflection of risk appetite, as well as a market gauge of an issuer's credit quality.

Analysts said the drop in the spread was also down to the effect of European Central Bank (ECB) quantitative tightening, which reduced the demand for sovereign bonds across the euro area.

"The main market focus is currently on the prospects of increased debt issuance to finance a package to revive the German economy," said Danske Bank Analyst Rune Thyge Johansen.

The two-year yield DE2YT=RR, which is more sensitive to ECB rate expectations, rose 6bps to 2.25% after falling 14.5bps the day before.

The German yield curve steepened further with the gap between 10-year and two-year yields DE2DE10=RR rising up to 26.8bps, a fresh two-year high.

"Fears of long-standing inflation in the US and its impact in the euro area are driving [long-dated] yields higher today with a further steepening of the yield curves," said Massimiliano Maxia, senior fixed income specialist at Allianz Global Investors, arguing investors expect Republicans to have a majority in Congress.

Republicans won control of the US Senate. If they ultimately prevail in the House, they will be able to dictate the agenda in Washington, helping Trump deliver on his promise to slash taxes and restrict immigration for at least the next two years until the 2026 midterm elections.

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