July 24 (Reuters) - Euro zone yields fell after a survey

showed German business activity unexpectedly contracted in July,

leading investors to increase slightly their bets for two

European Central Bank rate cuts by year-end.

The HCOB German flash composite Purchasing Managers' Index

fell to 48.7 in July, while growth in euro zone business

activity stalled.

Investors are also closely watching developments in the U.S.

election campaign as Vice President Kamala Harris is expected to

be the Democratic Party's candidate to face Republican Donald

Trump.

Germany's 10-year bond yield, the benchmark for

the euro zone bloc, dropped 2.5 basis points (bps) to 2.41%. It

was at 2.46% before Joe Biden abandoned his reelection bid.

Money markets increased their bets on future rate cuts,

pricing in a 90% chance of two ECB moves by year-end from less

than 80% before the PMI data.

Meanwhile, the yield gap between Bunds and OATs

- a gauge of the risk premium investors demand to

hold French government bonds - hit a fresh post-election high of

71.70 bps.

Citi analysts flagged in the morning note that the far-left

La France Insoumise's (LFI) proposal to reverse President

Emmanuel Macron's pension reform with support from the far-right

Rassemblement National (RN) triggered a widening gap between

French and German government bond yields.

"Our economists' base case remains for a 'truce' government,

which is unlikely to propose meaningful legislations like this,"

Citi rate strategists said.

"Further, it is not clear whether left parties other than

the LFI, whose support is needed to pass the bill, would want to

join hands with the RN for this purpose."

Macron said on Tuesday that his outgoing government would

remain in place until mid-August while France hosted the Olympic

Games, dismissing an effort by a left-wing alliance to name a

prime minister.

Markets feared that a new government led by the far right or

the far left could increase fiscal spending, increasing the risk

premium of France's public debt.

Italy's 10-year yield was higher by 1.5 bps at

3.77%, and the gap between Italian and German bund yields

widened slightly to 135 bps.

It hit 120 bps last week, a level not seen since before

Macron called for snap elections, sending jitters across

financial markets.