Challenges Ahead for Euro Area Bond Spreads Despite Recent Stability

Current State of Euro Area Bond Spreads

By Stefano Rebaudo

Yield Spread Trends

Feb 4 (Reuters) - Euro zone sovereign bond yield spreads are at their lowest since Lehman Brothers collapsed in 2008, but investors say steeper falls will be difficult without deeper reforms, as volatile geopolitics forces Europe to rethink spending.

Political and Economic Factors

The yield premium that Southern European governments pay over safe-haven German Bunds has shrunk almost non-stop since late 2023, when it became apparent the European Central Bank was going to cut interest rates. 

Future Outlook and Predictions

But market participants say there may be limited room for further declines to a unified point economists believe will help create a deeper and more liquid bond market, an essential step towards strengthening the euro’s role on the world stage.

The United States, under President Donald Trump, has become a less predictable partner, both for trade and security. His administration has insisted Europe must pay more for its own security, and euro zone governments, led by Germany, are planning huge increases in borrowing to fund that.

Trump's short-lived threat in January to take over Greenland prompted yield spreads to briefly edge higher, before retreating once more.

Italy, Spain, Portugal and Greece are at around 53 basis points, 37 bps, 24 bps and 43 bps, respectively. In 2007, before the crisis when debt loads were far smaller than today, spreads were even lower, with Italy at about 22 bps, Spain and Portugal at 5 bps, Greece at 25.

“It wasn’t always about fundamentals, (some) spreads were close to zero (before the GFC) because there was a hope that over time, the monetary union would evolve into a fully-fledged fiscal and political union,” said Konstantin Veit, portfolio manager at PIMCO, referring to the 2008 global financial crisis.

“We remain constructive on peripheral spreads, but compression potential might be limited without improvements on the institutional side,” he added.

Veit was referring to further progress on the banking union, capital markets union, common issuance and a shared fiscal capacity, something ECB President Christine Lagarde last year said was needed for greater international prominence for the euro.

EU INTEGRATION AND POLITICS

Given the strength in the euro, the ECB could deliver another rate cut this year, based on analyst forecasts and market pricing. This should help keep spreads stable this year, analysts said. 

On the political front, the EU’s pandemic‑era Next Generation fund and the growing need for higher military spending had fuelled expectations of more joint debt issuance. That in turn has supported the bonds of Southern Europe, an effect that analysts expect to last throughout 2027. 

Economists remain sceptical about greater joint issuance, given Germany’s opposition.

“I think more integration will only come in a stress scenario, and we're not yet in a stress scenario,” Carsten Brzeski, global head of macro research at ING, said. He mentioned the possibility of debt-to-GDP ratios increasing in Southern Europe if the economy slows.

“We can enjoy the good place, but we should be cautious in deriving any longer-term conclusions from the current state,” he added. 

Italy, long seen as politically unstable, has become one of Europe’s more stable countries, while German politics has become more volatile, in part as far-right, eurosceptic parties such as Alternative für Deutschland gain more power.

“Politics in Italy or other Southern European countries is the part I’m least concerned about,” Rohan Khanna, head of euro rates strategy at Barclays, said.

“What I’m more concerned about is how the market thinks about Italy in a post‑NGEU world.”

Barclays expects spreads to trade in a tight range, with less room for a decline in Italian spreads than those elsewhere in Southern Europe.

(Reporting by Stefano Rebaudo; editing by Amanda Cooper and Andrew Heavens)