Leaders of German Chancellor Angela Merkel's conservative party agreed on Sunday to pursue a "grand coalition" with the Social Democrats to break the political deadlock in Europe's biggest economy.

This together with strong economic data last week lifted the euro to two-month highs at $1.1957 on Monday.

The backdrop was favourable for regional debt markets, where strength in the currency dampens inflation and is seen encouraging the European Central Bank to maintain its ultra-loose monetary policy stance for a longer period.

"There is optimism about the formation of a grand coalition in Germany and economic surprise indices for the bloc are at an all-time high," said Antoine Bouvet, rates strategist at Mizuho.

"That means there could be more investment in Europe, driving the currency higher and the corollary to that is for markets expectations for ECB policy has to be more dovish."0

Bond yields across the single-currency bloc edged down, with yields in Spain, Italy and Portugal leading the way with falls of 3-4 basis points each .

Spain's 10-year bond yield briefly fell as much as 5 bps to a 2-1/2 week low of 1.447 percent, pushing the gap over German Bund yields to around 109 bps -- down from around 114 bps late on Friday.

The Italian/German bond-yield spread was about 4-5 bps tighter at 141 bps compared with late Friday levels.

Germany's 10-year yield was down 2 bps at 0.35 percent .

Analysts said a perception that Germany's Social Democrats (SPD) may be in favour of greater European integration compared with the pro-business Free Democrats (FDP) may be viewed in markets as positive for peripheral bonds.

Three-way coalition talks between Merkel's Christian Democrats and the FDP and Greens collapsed a week ago.

Talks on forming a new German "grand coalition" with the SPD may not begin until the new year, a top official in Merkel's conservative camp said on Monday. Still, hopes that a snap election would be avoided lifted risk sentiment, with share markets in Europe also higher.

"The only show in town today are the developments in Germany's political situation," said Rabobank rates strategist Lyn Graham-Taylor. "Perhaps people think the SPD will be more friendly towards integration and that is more positive for peripherals."