European sovereign bonds remain under significant pressure. This week, the spreads of French OATs against German Bunds at ten years have widened by around 15 basis points, while those of Italian BTPs have widened by approximately 10 basis points. France continues to be, by far, the market with the worst performance in the eurozone.
This development occurs despite increasingly attractive yield levels. Although the yields on ten-year OATs, around 5%, have attracted some opportunistic buyers, even substantial purchases by institutional investors have not managed to halt the widening of spreads for now. The thin market liquidity and selling pressures in the futures market are further amplifying the movement.
The combination of elections, difficult budget negotiations, and an increase in interest expenses poses considerable risks. In addition, a significant volume of new debt issuances is expected, as France and Italy regularly place more than 10 billion euros in bonds through auctions.
At the same time, the high supply faces a limited absorption capacity from the market. Given the reluctance of long-term investors to buy for fundamental reasons, the financial intermediaries in charge of placements (primary dealers) are forced to absorb larger volumes. The very high volatility is reducing their capacity to maintain risk positions in their portfolios. In our opinion, this creates a possible vicious circle that feeds back into itself, where selling pressures, rising yields, and deteriorating liquidity mutually reinforce each other.
Rating agencies could further exacerbate the situation. Possible rating downgrades or negative credit outlooks could further undermine the already fragile confidence of the market and amplify selling pressures in a pro-cyclical manner.
In this context, it is increasingly likely that the ECB will intervene verbally. However, it remains questionable whether this type of communication will be sufficient to restore market confidence in a lasting way. Ultimately, a credible political commitment to fiscal consolidation or a more forceful response from monetary policy may be necessary to break this vicious circle.
At the same time, pressure is increasing on the ECB to gradually relax the restrictive tone of its monetary policy. The widening of sovereign spreads is disproportionately tightening financing conditions in member states with weaker fiscal positions. Although we still believe that the ECB's intervention option ("ECB put") is very much off the table, the pressure on the central bank is clearly increasing.
Risks in the European sovereign debt markets are acquiring a self-reinforcing dynamic. We maintain a cautious view on France and Italy and have positioned the portfolios accordingly with short positions in OAT and BTP futures. At the same time, we are closely monitoring the possibility that new market dislocations may create attractive opportunities in sovereign issuers with stronger fundamentals.
