The premium that investors demand to hold French government bonds fell from a 12-year high on Monday after the first round of voting in the country's parliamentary election suggested a hung parliament was the most likely eventual outcome.

Investors hoped that there was now less chance that either the far left or the far right would have a free hand to roll out big-spending policies that could hurt France's fiscal position, analysts said.

Marine Le Pen's far-right National Rally (RN) party scored historic gains to win the first round of France's parliamentary elections, but the final outcome will depend on days of alliance-building before next week's run-off vote.

Political parties rushed to build a united front on Monday aimed at blocking RN's path to government.

There was a feeling of relief on the financial markets, but "we are not out of the woods yet," Alex Everett, investment manager at abrdn, said.

"The National Rally (RN) exceeded expectations, and may yet pick up the second round votes for a relative or even absolute majority," he added.

The 10-year German Bund yield rose 12 basis points (bps) to 2.61%, its highest in two weeks, as a flight to safety ahead of the vote reversed.

Bond yields move inversely with prices.

That caused the gap between French and German 10-year sovereign bond yields - a gauge for the risk premium investors demand to hold French bonds - to tighten by 6 bps to 74 bps.

It hit 85.2 bps on Friday, its highest level since July 2012, and was less than 50 bps before President Emmanuel Macron called snap elections.

France's 10-year government bond yield hit a fresh 8-month high at 3.355%, and was last up 6 bps.

"Given the division in the French parliament, we find it unlikely that the new government can find support for any larger increases in spending," Rune Thyge Johansen, euro area economist at Danske Bank, said.

The debt risk premium for other euro area countries also fell as investors saw France as less likely to endanger the stability of the bloc.

The spread between German and Italian 10 year yields narrowed 8 bps to 150 bps and Greek, Spanish, Portuguese and Belgian spreads also tightened.

But France's public finances are likely to come under more strain no matter the outcome of a snap parliamentary election.

The European Commission said two weeks ago that France, Italy and five other countries should be disciplined for running budget deficits over EU limits.

Rating agency S&P Global, which recently downgraded France, said in early June that policies advocated by the far-right National Rally could affect the country's rating.

Citi analysts said last week the French yield gap would tighten to 70-75 bps if RN leads the government, and implements just part of its fiscal plans, and would widen to 100-105 bps if RN carries out most of its budgetary goals.

Such a backdrop would also affect the debt risk premium in Italy, the bloc's most vulnerable country. The gap could reach 140 bps or 155 bps, in the same two scenarios of RN in government.

Investors also were watching German inflation data, which resumed its downward trend in June, leaving the door open for another rate cut by the European Central Bank in September.

The ECB cut rates by 25 basis points in June, and markets currently expect it to cut rates at least once more this year, and see around a 50% chance of a third rate cut.

  - Reuters