German bond auction fails as French election nerves ease

* First (Other OTC: FSTC - news) technical failure of Schatz auction since November

* German two-year yield hits 2-month high

* French/German yield gap touches 2-month low

* Polls show Macron firm favourite for French presidency

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

By John Geddie

LONDON, March 28 (Reuters) - The premium investors demand to hold French bonds fell to a two-month low on Tuesday as money managers baulked at a sale of safe-haven German debt, a sign that market tensions around the upcoming French elections have eased.

An opinion poll on Tuesday showed centrist Emmanuel Macron with a more than 20-point lead over far-right, eurosceptic Marine Le Pen (Other OTC: PENC - news) for the run-off vote in May. Francois Fillon is also seen comfortably beating Le Pen in a run-off despite scandals engulfing the conservative candidate.

French 10-year bond yields fell 3 basis points to 0.93 percent, closing the gap with German equivalents to a two-month low of 56 basis points.

Meanwhile the yield on short-dated German bonds - seen as one of the lowest-risk assets in the euro zone - held near a two-month high touched earlier on Tuesday following weak demand at an auction of the debt.

Just over 3 billion euros of bids were received for Germany's two-year auction, below the 4 billion euro target. That made it the first technical failure at an auction of two-year bonds since November, according to the German debt management agency.

"There was a thought that you would want to hold high-grade collateral ahead of the French elections in case you see a market-negative outcome," said Patrick O'Donnell, an investment manager at Aberdeen Asset Management (Frankfurt: 899502 - news) .

"But the polls appear to be pointing towards a far more benign outcome relatively to what we saw in February." O'Donnell said he was not interested in holding two-year German bonds.

Weaker demand for the German paper also suggests banks have sufficient amounts of these bonds that are needed as collateral over reporting periods at quarter- and year-end.

It could also reflect growing expectations that the European Central Bank may raise interest rates as soon as December as it winds back its monetary stimulus.

Money market rates suggest investors see around a 70 percent chance of a rate rise at the ECB's December meeting, down from as high as 80 percent earlier this month.

"It comes as the ECB appears to be preparing the market for a possible rate rise and so you have less incentive to park money at the short end of the German curve," DZ Bank strategist Rene Albrecht said.

Germany's two representatives on the ECB's main policy-making body called on Monday for it to prepare to wind down its aggressive stimulus policy as soon as economic conditions allow.

But Peter Praet, the central bank's chief economist and a key ally of ECB President Mario Draghi, warned on Monday that a rebound in euro zone inflation could stall or even reverse if the ECB removed stimulus too early.

German two-year yields climbed nearly 2 basis points in early trading to minus 0.685 percent, the highest since Feb. 2, and stood at around minus 0.70 percent after the auction.

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(Editing by Mark Heinrich)