- EU policymakers are increasingly concerned that governments are not grasping the seriousness of the bond market situation, according to an EU official speaking anonymously. Countries keep asking Brussels to relax fiscal constraints while the market is seeking predictability, the official said, adding that interest rate increases aimed at taming Iran war-driven inflation remain manageable only if countries respect their spending targets.
- Investors on Friday were charging the biggest yield premium to hold French bonds over German debt since the continent debt crisis fifteen years ago. Italy spread against German bonds is set for its widest weekly move since March 2020 and Spain gap has also grown, though both remain below crisis-era levels.
- Requests for leeway are being driven by energy costs, with Brent hovering around $100 a barrel. Italy and Greece have both recently sought additional flexibility from the European Commission, which polices deficit and debt levels. The bloc has already granted some exemptions for rearmament and limited energy measures.
- France, the epicentre of the selloff, has questioned relaxing budget rules and announced a budget this week containing a €54 billion plan, about $61.2 billion, to curb spending and reduce the deficit to 5% of output in 2027 from 5.4% this year.
What Happened?
A second EU official said euro-area governments are likely to face considerable market pressure in coming months. The Commission blessing is no guarantee investors will finance governments at sustainable levels, the first official noted. A Commission spokesperson did not immediately reply to a request for comment. Warnings against further borrowing increases are expected when EU finance ministers meet next week in Luxembourg, where energy prices are also on the agenda.
Why It Matters?
The official comment about the Commission blessing not guaranteeing finance describes a structural shift in how European fiscal policy is actually disciplined. For years the debate was whether Brussels would permit borrowing, with the fiscal rules as the binding constraint. Now the constraint is whether investors will fund it at a tolerable price, and that is a harder authority to negotiate with. Governments seeking flexibility are asking the wrong institution for permission. France illustrates the point uncomfortably. It is the country resisting relaxed rules and announcing €54 billion of consolidation, and it is also where the selloff is worst, with its premium over German debt at levels last seen in the euro crisis. Fiscal virtue has not protected it, which suggests markets are pricing something beyond deficit ratios, most plausibly doubts about whether consolidation plans survive contact with politics. Anyone assuming spreads respond mechanically to announced austerity should note that they have not here. The pace rather than the level is what should concern investors. Both Italian and Spanish spreads remain below crisis levels, but Italy widening fastest since March 2020 is the kind of move that becomes self-reinforcing if it continues, because European banks hold substantial domestic sovereign debt and marking those positions down weakens the institutions that buy them. The energy link completes the bind. The same shock that raises spending needs, through subsidies and cost-of-living support, also raises borrowing costs by driving the inflation that forces central banks to tighten. Governments are being squeezed from both directions by a single cause, and neither fiscal rules nor monetary policy addresses the underlying supply problem.
What Next?
The Luxembourg finance ministers meeting next week is the immediate venue, and whether ministers accept the warning or press for more flexibility will indicate how seriously the market signal is being taken. Watch the French spread over German bunds as the primary gauge, since it is the source of the current stress, and whether Italian and Spanish spreads continue widening at this week pace or stabilise. Any further requests for exemptions from Italy, Greece or others would test the Commission position. The G7 diesel release and any easing in energy prices would relieve both sides of the squeeze at once, making oil the variable worth watching most closely. European bank exposure to domestic sovereign debt is the transmission channel to monitor if spreads keep moving.
Affected Tickers and Coins: EWQ, EWI, EUFN
Source: Bloomberg
