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

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European government bond prices dropped sharply on Thursday as investors took fright at Italy’s larger than expected budget deficit and mounting concerns that central banks will keep interest rates high for an extended period.

Italian 10-year government bond yields rose as much as 0.17 percentage points to 4.96 per cent, their highest level in a decade, after prime minister Giorgia Meloni’s government raised its fiscal deficit targets and cut its growth forecast for this year and next. The yield later fell back to 4.88 per cent.

The sell-off spread to UK markets, where 10-year yields rose as much as 0.2 percentage points to 4.57 per cent — the biggest daily rise since February — before ending the day at 4.48 per cent. Investors said concerns that the US Federal Reserve would hold rates “higher for longer” were spreading to European markets.

“A wall of worry is hitting the bond market and the latest trigger is the oil price,” said Jim Leaviss, a fund manager at M&G Investments. He added that the rise in the oil price, which hit a 10-month high on Thursday, was causing investors to wonder “what if inflation is not dead?”

In the euro area, the prospect of higher Italian borrowing came after the French 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. 

France’s 10-year bond yield jumped to more than 3.5 per cent, its highest level since 2011. 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.

“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.”

Concerns about elevated borrowing have piled further pressure on a bond market already roiled by worries over a protracted period of high interest rates. Ten-year German yields — the eurozone’s benchmark — climbed as high as 2.98 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 historic 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.

Analysts said Thursday’s moves were particularly sharp in the UK because gilts had rallied in recent weeks as markets positioned for an end to the Bank of England’s cycle of rate rises. Investors who had positioned for lower yields rushed to sell as the market moved against them, according to TD Securities strategist Pooja Kumra.

US Treasury yields have climbed sharply since the Fed last week indicated it would cut rates much more slowly next year and in 2025 than investors had been pricing in. The 10-year yield was little changed on Thursday at 4.61 per cent.

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

He added: “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.”

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.

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 providing an incentive to Italians to have more babies.

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