Bond market plot twist puts Europe’s recovery at risk

The 10-year German bund yield has turned positive after almost three years below zero. It’s a sign of the times as government borrowing costs are on the rise globally. With the euro zone’s nascent economic recovery more fragile than that of the US, however, the European Central Bank needs to remain vigilant that increased market interest rates don’t choke growth.
Renewed hawkishness at the Federal Reserve has spooked the bond market, with the 10-year Treasury yield approaching 1.9% from 1.5% at the end of last year. German levels have duly increased, climbing above zero after averaging -0.3% in 2021. Foreign holders exiting euro zone debt for the higher income available in the US will naturally drive yields higher unless there is sufficient demand within the euro zone to soak up the slack. The ECB, the biggest buyer in the room, is still scooping up bonds as part of its stimulus effort. Its pandemic quantitative easing program, known as the PEPP, is drawing to a close in March to be replaced by a pre-existing, albeit smaller, package.
While European bonds haven’t been able to avoid the upward pressure exerted by the climb in US government borrowing costs, they have put up some resistance. The yield gap between 10-year bunds and US Treasuries has widened, to about 188 basis points currently from fewer than 170 basis points at the end of last year, reflecting the faster pace of rising yields in the US bond market. That trend is expected to continue; the consensus forecast of economists is for the differential to remain above 180 basis points by the end of the first quarter.
The more yields rise elsewhere, the greater the attraction for investors to shun the very low income available from European debt in search of more attractive returns across the pond.
Higher yields look inevitable even if the asset purchase program is employed skillfully to smooth yield jumps, and particularly to combat any wild swings in the spreads of peripheral countries above that of the German benchmark. Keeping bund yields pegged helps significantly with restricting Italian levels from rising too sharply — the key stress test point of the euro project.
By breaching zero and turning positive, German bonds have made a symbolic break with recent market history and illustrate that even the Herculean multi-trillion efforts of the ECB can’t hold back the tide indefinitely. Policy makers in the euro zone need to remain alert to the risk that market influences from overseas could undo their efforts to keep a lid on domestic government borrowing costs.
—Bloomberg