European sovereign bonds are sounding the alarm, but the stock market is still strong! The difference between France and Germany recorded the biggest weekly increase in more than 30 years, and Deutsche Bank warns that a departure from the situation may be difficult to sustain

The Zhitong Finance App learned that the European sovereign bond market experienced clear pressure this week, but the European stock market and corporate credit market reacted lackluster, creating a rare divergence between different asset classes. Henry Allen, a macro strategist at Deutsche Bank, pointed out that compared with the performance of the European market when risk spread in the past, interest spreads on sovereign bonds have widened dramatically, but not accompanied by a sharp decline in risk assets. This situation is “very unusual.” Deutsche Bank believes that this divergence is difficult to sustain for a long time. If financial pressure is not quickly relieved in the near future, risk assets such as the European stock market may face increasing downward pressure.

Interest spreads on 10-year French and German treasury bonds hit the biggest weekly increase in more than 30 years

Weekly fluctuations in the European sovereign bond market are particularly noteworthy. According to the data, the difference in yield on 10-year treasury bonds between France and Germany widened by 32 basis points in a week, the biggest weekly increase recorded by Bloomberg since German unification in 1990, and pushed the interest rate spread on French and German 10-year treasury bonds to the highest level since 2012. At the same time, the difference in yield on Italian and German 10-year treasury bonds also widened by 23 basis points, showing that the pressure on the European sovereign bond market is not concentrated only on France.

Sovereign bond yield spreads are generally regarded as an important measure of how concerned the market is about different countries' fiscal and credit risks. German treasury bonds have long been regarded as the benchmark asset in the Eurozone, so the rapid rise in yield premiums in countries such as France and Italy over German treasury bonds means that investors are demanding higher risk compensation.

Allen pointed out that the trend in the European sovereign debt market last week is reminiscent of market performance during previous rounds of crises. During the 2011-2012 European debt crisis, March 2020, and market turmoil in 2022, while the pressure on the sovereign bond market spread to other assets, the European stock market also usually experienced a significant decline.

But this time around, the response from other risky assets was significantly more moderate.

The sovereign bond market is in sharp turmoil, and the trend of the European stock market and credit bond market is relatively stable

Despite the sharp widening of interest spreads on European sovereign bonds, the European Stoxx 600 index fell by only 1.1% last week, and is still less than 4% below its all-time high. The European corporate credit market also did not show a level of tension to match that of the sovereign debt market. As of last Friday, credit spreads on Eurozone investment-grade corporate bonds had risen to 101 basis points, but they are still significantly lower than during the past few rounds of market pressure.

Allen said that interest spreads on sovereign bonds have widened dramatically, while the decline in the stock market is limited, and corporate credit spreads have also only moderately widened. These situations are “very unusual” at the same time. In other words, the European interest rate market and other risk assets currently clearly disagree with the signals given by the economic and financial outlook.

Deutsche Bank believes that judging from the performance of the sovereign bond market, the interest rate market has begun to take into account the risk spreading to other markets and the possibility that economic growth will be significantly impacted; however, similar pessimistic expectations have not been fully reflected in the pricing of stock and corporate credit markets.

This divergence between assets also means that either the tension in the sovereign bond market will quickly subside in the future, or other risky assets may need to be repriced to reflect the risks already reflected in the interest rate market.

Market divergence is difficult to sustain risky assets or is under greater pressure

Deutsche Bank believes that the current pricing misalignment between different asset classes in Europe is unlikely to continue for a long time. A relatively optimistic scenario is that pressure on the sovereign bond market has eased rapidly recently. Deutsche Bank compared this to the market trend after the bank of Silicon Valley went out of business in March 2023 — the financial market was in sharp turmoil at the time, but the pressure subsided relatively quickly, and did not continue to evolve into a wider sell-off of risky assets.

However, if the recent pressure on the European sovereign bond market cannot be quickly reversed, then risk assets such as stocks and corporate credit may find it increasingly difficult to maintain their current relatively calm performance. This means that the key issue currently facing the European market is not only the yield on sovereign bonds itself, but whether the risk signals released by the bond market are eventually transmitted to other asset classes.

In the past few rounds of market crises, the sharp widening of interest spreads on sovereign bonds is usually accompanied by a decline in investors' risk appetite, a drop in stock prices, and a widening of corporate credit spreads. If the current tension in the European bond market continues and the stock market is still close to historic highs, the pricing difference between the two may widen further.

As a result, Deutsche Bank warned that unless the financial pressure experienced in the past week abates quickly, European risk assets may face increasing pressure. At present, the sovereign bond market has begun to reflect the spread of risk and the possibility that economic growth will be significantly impacted, yet the European stock market and the corporate credit market have yet to respond to this to the same extent.