Analysis-Fiscal rules revamp may threaten calm in euro zone’s fragile bond markets

© Reuters. FILE PHOTO: Italian Prime Minister Giorgia Meloni and German Chancellor Olaf Scholz address the media during their meeting at the Chancellery in Berlin, Germany, November 22, 2023. REUTERS/Fabrizio Bensch

By Stefano Rebaudo

(Reuters) – The recent calm in bond markets of the most indebted euro zone nations could quickly flip to turmoil in 2024 if investors already nervous about debt sustainability and high interest rates are spooked by more rigid post-pandemic budget rules.

Analysts believe Germany’s budget crisis will mean tougher fiscal policy in the largest euro zone economy in 2024, which could add to pressure on less wealthy members of the bloc to keep a tighter grip on their finances.

That could reverse a trend that has seen the premium investors demand to buy bonds of euro zone governments over benchmark Germany shrink more this year for indebted economies like Italy than it has for the “core” of wealthier countries.

Italian 10-year bonds currently yield around 173 basis points more than German debt, 38 bps less than a year ago, while the gap between Portuguese and German yields has narrowed by 34 basis points. French bonds meanwhile yield 58 bps more than German, 5 bps more than a year ago.

Investment bank BofA nonetheless warns that Italy’s huge debt burden means it is “one shock away from threat to debt sustainability”.

“The euro area has to avoid making the same mistake it made more than a decade ago, when both fiscal policy and monetary policy were too tight,” said Ruben Segura-Cayuela, European economist at BofA.

“Too-aggressive simultaneous tightening could threaten the resilience that the periphery, and peripheral spreads, have shown so far.”

During the European sovereign debt crisis of 2010-2012, some countries – including Greece, Italy and Spain – saw their borrowing costs rocket, raising questions over how easily they might be able to repay their debts.

European Union finance ministers are in the process of revamping the roughly 30-year old Stability and Growth Pact, which limits budget deficits to 3% of GDP and debt to 60%, with disciplinary measures for those that break the rules.

Those limits have been suspended since 2020 due to the COVID pandemic and surging energy prices, and the splurge in government borrowing to cover the costs of those two crises has partly been behind the drive to reshape the fiscal framework.

There could be a political agreement as early as next week, but it may take until after European parliamentary elections in early June to reach a final deal.

Some countries, including Italy, asked for a more lenient approach focused on growth, while Northern members led by Germany put more emphasis on reducing debt.

The European Commission initially proposed that any decline in debt over four years should be acceptable. Germany insisted on minimum annual amounts, that would be the same for all.

“New rules need to move away from the ‘one size fits all’ and numerical targets while leaving room to deal with the long-term challenges of the region,” BofA’s Segura-Cayuela said.

Germany’s own finances have been thrown into disarray by a court ruling last month that a government move to use 60 billion euros of unused COVID funds for climate spending was unconstitutional. Berlin has had to freeze its budget plans for this year and next and suspend a self-imposed cap on borrowing, known as the “debt brake” for another year.

“Where we stand now, the signal from Berlin is that Germany wants to stick with its debt brake. If so, finding a compromise on the Stability and Growth Pact could be more difficult as there is little probability that Germany may soften its stance,” said Felix Hubner, chief German economist at UBS.

Analysts argued the German public may be unwilling to accept a tightening of domestic fiscal policy without a blanket approach across Europe – meaning a tougher scenario for the periphery.

The European Commission initially proposed that any decline in debt over four years should be acceptable, while Germany has insisted on minimum annual amounts, called benchmarks, that would be the same for all.

Bondholders are meanwhile banking on the European Central Bank cutting interest rates in a few months, which should support euro zone peripheral debt.

JPMorgan sees the Italian-German yield gap at 175 bps by mid-2024 and 200 bps by year-end, assuming the ECB support for the periphery is unchanged.

Allianz (ETR:) Global Investors has been neutral on peripheral bonds since late summer and sees the Italian-German at 180-200 bps as long as Italy keeps its investment-grade credit rating and the ECB policy path is what markets currently expect, senior rate specialist Massimiliano Maxia said.

($1=0.9112 euros)

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