UPDATE 2-Euro zone bonds sell off after EU, UK negotiators said to be close to draft Brexit deal

Eurozone government bonds sold off on Tuesday after a news report that UK and EU negotiators were close to a draft deal on Brexit boosted investors' risk appetite. All focus this week is on the prospects of a Brexit deal being agreed that will help the United Kingdom depart from the European Union in an orderly fashion, ahead of a European Council summit where it could be put to the approval of the EU leaders.

European Union and UK negotiators are closing in on a draft Brexit deal, which could be published on Wednesday morning, according to news reports from Bloomberg and the Guardian. "It's potentially removing one of the key risks that have been out there," said Commerzbank rates strategist Rainer Guntermann.

"There are certainly some remaining issues and …. this implies the risk on trend could continue if all this is confirmed on the UK side, in parliament," he added. German 10-year government bond yields rose to 2.5-month highs, up as much as 5 basis points on the day, with a sharp sell-off taking place following news of the potential draft deal.

Money markets scaled back expectations of a rate cut, to as low as a 10% chance of a 10 bps rate cut from the European Central Bank in December, down from a 20 bps probability on Friday. A key gauge of long-term inflation expectations reached three-week highs at 1.21% as a deal would ease economic uncertainty.

Safe-haven German government bonds are extending losses after a heavy sell-off last week when the 10-year yield went up 15 bps on optimism over Brexit and prospects for a U.S.-China trade deal, which eased uncertainty about the global economic outlook. The EU's chief Brexit negotiator Michel Barnier is expected to brief EU governments on the progress of a potential deal on Wednesday.

Irish bonds continued to benefit from progress on Brexit talks, with the gap between the 10-year bond yield and its German peer falling to its lowest level since July, at 43 bps. Spread between Irish and German yields https://tmsnrt.rs/32inJAn

"We are watching the Irish spread. It hit a low in July and then the worries about a no-deal Brexit meant the spread widened," said Daniel Lenz, a rates strategist at DZ Bank. "But in recent days, in particular, we have seen a tightening in the spread and that shows investors are less concerned about Brexit."

In the eurozone, the mood among German investors worsened only slightly in October, a survey showed on Tuesday, beating an analyst consensus for a bigger drop amid concerns that Europe's biggest economy could be headed towards a recession. Jean-Christophe Machado, fixed income strategist at Natixis said he is not keeping a close eye on such indicators like the sentiment survey. He was instead keen on seeing the sentiment index and PMIs following a Brexit deal, adding that even a no-deal Brexit could potentially lead to an improvement.

"Some people might say it's behind us now and we know what's happening," he added.

Also Read: UK PM's adviser Cummings: Brexit will happen on Oct. 31