Eurozone bond market hit by Italy’s plans for higher borrowing

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Eurozone government borrowing costs rose to their highest level in more than a decade on Thursday as investors reacted to elevated Italian and French budget deficit forecasts and expectations that central banks will keep interest rates higher for longer.

The spread between Italian bond yields and their ultra-safe German equivalents — a closely watched measure of market risks in the euro area — reached its widest level since the US banking crisis in March after Italian prime minister Giorgia Meloni’s government raised its fiscal deficit targets and cut its growth forecast for this year and next.

Italy’s 10-year yield rose 0.12 percentage points to 4.89 per cent, its highest level since 2013. France’s 10-year bond yield jumped to 3.5 per cent, its highest level since 2011 after the government was criticised by the country’s fiscal watchdog on Wednesday for not cutting public spending enough to avoid breaching EU fiscal rules next year. 

“The narrative that’s taken over is a fiscal story, said Mike Riddell, a fixed income portfolio manager at Allianz Global Investors. “Budget deficits are likely to be bigger than previously expected. So you do have the re-emergence of the bond vigilantes — where markets are just not tolerating what appear to be not just cyclical but structurally higher deficits.”

The concerns about elevated borrowing have piled further pressure on a bond market already in the middle of a global sell-off sparked by worries over a protracted period of elevated interest rates. Ten-year German yields — the eurozone’s benchmark — climbed to 2.93 per cent, their highest level for more than a decade. Spain’s 10-year bond yield shot above 4 per cent for the first time since 2013.

Central banks have signalled that while they are close to ending their unprecedented series of interest rate increases, they expect borrowing costs to stay at a high level for a prolonged period to ensure inflation comes down to their targets before considering cuts.

A retreat in US bond prices accelerated this week after the Fed last week indicated it would cut rates much more slowly next year and in 2025 than investors had been pricing in.

Piet Haines Christiansen, director of fixed income research at Danske Bank, said the bond market was “caught in a perfect storm”. 

“The ‘higher-for-longer’ has caught investors with wrong positioning off guard, which coupled with the higher revisions to the French and Italian budget deficits as well as the higher oil price keeping inflation expectations elevated has driven this sell-off,” he said.

The surging borrowing costs were reflected in a €3bn sale of 10-year bonds by the Italian treasury on Thursday. These gave investors a 4.93 per cent yield, the highest since 2012 and an increase from the 4.24 per cent on a similar bond last month.

The gap between Italy’s 10-year bond yield and its German equivalent widened to just below 2 percentage points, close to a one-year high hit in March.

Italy’s government late on Wednesday predicted this year’s fiscal deficit would come in at 5.3 per cent of gross domestic product, up from the 4.5 per cent target it set in April, citing the soaring cost of a controversial tax credit scheme for home improvements. 

Rome increased next year’s deficit target to 4.3 per cent of GDP, up from its early target of 3.7 per cent, which it said would allow it to fund its top policy priorities, including helping low-income families and incentivising Italians to have more babies.

“The upside surprise in Italian deficit projections is the obvious catalyst for the widening in spreads today, which would translate into [a] larger supply of bonds for markets to absorb,” said Frederik Ducrozet, head of macroeconomic research at Pictet Wealth Management.

Soaring oil prices added to market worries about persistent inflation and tight monetary policy. Brent crude jumped almost 3 per cent on Wednesday to a 10-month high of more than $97 a barrel.

“I think that the impact of these market moves means that the risk of recession and the risk of financial accident is just getting bigger and bigger,” said Riddell at Allianz.