Euro zone government bond yields rose on Tuesday as investors worried about the risk that geopolitical tensions in the Middle East could boost inflation expectations, slowing down the European Central Bank's easing path.

The price of crude oil, one of the main drivers of consumer prices, dropped after surging more than 7% in the previous three sessions on supply concerns prompted by fears of widening Middle East conflict and a shutdown of some Libyan oil fields.

Investors remained cautious before the release of the bloc’s August inflation data later in the week, which could provide clues about the ECB's monetary policy path.

Germany's 10-year government bond yield, the benchmark for the euro zone, rose 2.5 basis points (bps) to 2.27%, after hitting 2.276%, its highest since Aug. 8.

Markets also closely watched political developments in France.

President Emmanuel Macron appeared to be back to square one in consultations to form a new government as Socialists and Greens said they would not participate in further talks.

Macron thinks the balance of power lies more with the centre or centre-right. But any such alliance would also require driving a wedge through the left to win backing from its more moderate factions, something leftist leaders have repeatedly ruled out.

"The default option (without a new government) would mean a budget drawn up by the caretaker prime minister Gabriel Attal," said Edmond de Rothschild Asset Management.

"Ten billion euros in cost-cutting is planned, but that would be less than expected by Brussels in its excessive deficit procedure against France."

Parliamentary approval of the 2025 budget is one of many tests at a time when France is under pressure from the European Commission and bond markets to reduce its deficit.

RISK PREMIUM

The yield gap between French and German government bonds - a market gauge of the risk premium investors demand to hold France's public debt - widened to 72.5 bps. It hit 88 bps in early August, its highest since 2012, and reached 85 bps during French elections.

Germany's two-year bond yield, more sensitive to expectations for policy rates, was up 1 bp at 2.40%.

Analysts said the ECB still sounded intent to proceed cautiously with quarterly cuts. Easing moves in-between meetings are likely to come into play if data on euro area inflation falls more abruptly.

Market bets on ECB rate cuts barely moved after the Federal Reserve policy meeting last Friday and cautious remarks by ECB officials about the easing cycle during the weekend.

They priced in around 65 bps of rate cuts by year-end , which implies two rate cuts and a 60% chance of a third move, not far from the levels seen last week before the Fed.

They also fully discounted a 25 bps cut and an about 30% chance of a 50 bps move by the Fed in September.

San Francisco Fed President Mary Daly said late Monday "the time is upon us" to reduce interest rates, likely starting with a quarter-percentage point.

Italy's 10-year yield, the benchmark for the euro area periphery, was up 6 bps at 3.65%, and the gap between Italian and German bunds widened to 137 bps.

(Reporting by Stefano Rebaudo; Editing by David Holmes)