Euro-area bond yields inevitably leapt like a salmon as Germany unleashed a fiscal bazooka, but compared to previous fixed-income tantrums, it’s not the stuff of all-night summits.
What's key is what the bond rout isn’t: A reaction to fears that one or more countries is coming under financial stress. It’s a broad selloff that started in Germany and swept through the rest of the euro zone — and then spread to Asia — almost indiscriminately. It's extraordinary for US yields to be lower when the entire euro yield curve has risen as much as 30 basis points. This is a genuine repricing to accommodate half a trillion euros of unexpected spending.
Peripheral nation yields are certainly rising - as Brussels has made sure they can do their bit for regional security. Importantly, though, their borrowing costs aren’t blowing out disproportionally and stirring a flight to higher-rated German debt. There's no sudden existential crisis that weaker economies can't pay their bills or borrow freely across the yield curve. Investors should happily help themselves to higher bond yields. That the euro is up more than 3% versus the dollar this year, second only to the yen among major currencies, confirms this is Europe helping itself the right way.
It's encouraging for European Union credibility that the largest economy is leading the charge on boosting defense. Certainly if some of Germany's struggling auto industry can be repurposed it could reignite growth after two long years of recession and the dim prospect of a third contraction this year.
German debt is the benchmark for how wider euro area yields are assessed. Over the past six months, it's become less of a carefully rationed risk-free asset and more liquid, especially for repo borrowing. The consequence is that spreads for other frugal euro area peers can become tighter, or even trade beneath German yields. This has already happened for interbank swap rates.
However, not all is perfect in the European Garden of Eden. Two problem children still stand out: France and Italy.
French Prime Minister Francois Bayrou seems to have the Napoleonic "Lucky General" touch, as he not only has managed to get an annual budget through the legislature, where his predecessor Michel Barnier failed, but now Brussels is welcoming sharply increased defense spending.
The French yield curve hugs reasonably close to the German equivalent in shorter maturities but widens out to a 70 basis-point premium for 10-year notes. French yields suffered a sharp uplift from the sub-50 basis point level above Germany before President Emmanuel Macron called surprise elections in early summer that resulted in political chaos. Any residual glow from the summer Paris Olympics dissipated quickly as France's budget deficit to gross domestic product is expected to remain above 6%, well above EU guidelines.
Fears over France's creditworthiness have subsided from the near-90 basis point premium to bunds in early December when Barnier's budget efforts collapsed. Yet it no longer benefits from the "Bunds-plus" accolade that Japanese investors once applied, believing that France was so integral to the euro project they’d get the extra yield for taking minimal extra political risk. Japanese funds have unloaded more than €25 billion ($27 billion) of French debt since the middle of last year, according to Bloomberg Intelligence data.
France needs to place €330 billion of new bonds to raise this year, before it undertakes any kind of spending plan akin to Germany’s. It might be heavy weather finding investors to offset the exodus by Japan funds. If any stress were to appear it would be in raising ultra-long maturities. Happily for France, last month’s €8 billion issue of 30-year bonds was oversubscribed 14 times and distributed to 420 investors. Still, don't be surprised if Paris pushes for common EU defense bonds.
Italy under Prime Minister Giorgia Meloni has been boxing clever across a wide range of political fronts and won a reprieve from the European Commission’s budgetary purgatory. Italy's deficit is not far from French levels but its direction of travel is more clearly reducing - though of course it has benefited by far the most from EU pandemic relief funds.
In response, investors have rewarded Italy by tightening to 110 basis points its bond yields relative to Germany from more than 150 basis points last year. Obviously Italy cannot afford much higher yields with the ease that Germany could but with 10-year yields still under 4% it's not near the danger zone yet. The nation raised 15% of its near €300 billion annual issuance in January, the most of any euro nation, and has followed up with more of its popular retail bonds. Sticking to the righteous path has kept Italy off the naughty step.
If the euro’s appreciation is the yardstick, everything looks peachy. However, that move is being driven more by the dollar weakening on signs of faltering US growth, only a small part of which is tariff induced. It's always a fine balance for the euro between being too weak that investors begin to doubt its unity, or so strong it chokes off growth for its export-led economy. The move away from parity to the greenback is clearly reassuring, but a surge of strength may not be welcomed by the European Central Bank in gradual easing mode.
A bolder Europe that’s ready to help itself is a refreshing change. The somnambulant euro economy can use the break.
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