Bond yields rise in Europe as the old jitters return
Yields on European government bonds rose the most in months on Thursday and Friday after European Central Bank President Christine Lagarde reignited fears about the ability of weaker members of the euro zone to withstand higher borrowing costs.
Investors quickly dumped government bonds, pushing the benchmark 10-year German Bund to 0.2% on Friday, its highest yield in nearly three years and solidly in positive territory after years of negative yield. . A better-than-expected US jobs report also contributed to the upside, pushing bond yields higher around the world.
The yield on Italian 10-year bonds jumped the most since December 2020 on Thursday and rose again on Friday to 1.7%. It was at 1.25% at the start of the week. The spread between Italy’s bond yield and the German benchmark, seen as a barometer of financial stress in the region, hit its highest level in more than 18 months.
“Every country, even in Europe, is starting to accept that inflation is more rigid,” said John Roe, head of multi-asset funds at Legal & General Investment Management.
The surge in yields weighed on equity markets across the region, with the Euro Stoxx index closing down 1.6% on Thursday and falling a further 1.1% on Friday. The euro strengthened more than 1% against the dollar as traders anticipated that higher interest rates would attract capital flows to the euro zone.
The bloc has a long history of divergent economic growth between the prosperous north, in countries like Germany and the Netherlands, and the heavily indebted south, led by Italy, Greece and Spain. Vigorous action by the ECB, including deeply negative policy rates and a massive bond-buying program – expanded during the pandemic – has quelled fears about these differences.
But record inflation is forcing the ECB to catch up with the Federal Reserve, which signaled an interest rate hike in March, and the Bank of England, which raised rates for the second straight time on Thursday. A tightening of ECB policy threatens to choke off the ultra-cheap borrowing that countries like Italy have used to try to reset their economies as they emerge from the pandemic, and could cause a downturn.
“As the ECB starts to normalise, that means more risk in southern European economies,” said Carsten Brzeski, global head of macroeconomic research at Dutch bank ING. They are more dependent on support from the ECB, he said.
Eurozone member states show a wide divergence in economic power, with debt loads ranging from 206% for Greece and 156% for Italy to 70% for Germany at the end of 2020. Yet, borrowing costs converged to a narrower band during the pandemic as the ECB bought bonds and kept yields artificially low, especially for those with more unstable economies.
In a sign of fears that a tightening cycle is hampering the recovery in Europe, shorter-dated German bonds sold more than longer-dated debt, flattening the yield curve at the fastest pace in nearly four months. The spread between two- and 30-year bond yields fell to its lowest level since December on Friday.
The flattening of the yield curve is a sign of a slowdown in growth to come, or even a recession if the monetary tightening is too strong, said Jorge Garayo, fixed income strategist at Societe Generale.
Laurent Crosnier, chief investment officer at Amundi’s London branch, is betting that shorter-dated eurozone bonds will lose more value as the ECB follows the Fed and Bank of England and tightens monetary policy.
“All these central banks are tightening, this is just the beginning,” Crosnier said.
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