What is driving Europe’s yield decoupling?

A widening gap between European government bond yields is creating a hidden peril for financial markets, as borrowing costs across key Western European economies approach levels not seen in almost 20 years, according to KB Securities.

According to the note, 10-year government bond yields in leading Western European economies have climbed above their 2023 highs and are nearing levels last recorded in 2007. At the same time, the U.S. 10-year Treasury yield stands above 4.8% but has not yet reclaimed its 2023 peak.

The more pressing issue is the growing gap between Western and Southern Europe. French and German yields have moved up sharply, whereas yields in Spain and Italy remain below their 2023 peaks and have climbed at a slower clip. KB Securities describes this as striking because euro-area members share both the single currency and the European Central Bank's monetary policy.

Fiscal positions help explain the divergence. France and Germany are projected to run budget deficits of roughly 5% to 6% of GDP next year, versus 2% to 3% for Spain and Italy, which keeps the latter broadly within the European Union's 3% fiscal-deficit limit. Germany is also expected to step up borrowing for defence and infrastructure, while France has had difficulty maintaining fiscal-tightening measures due to political and public opposition.

This divergence mirrors the run-up to the 2011 euro zone sovereign debt crisis, when yields across member states began drifting apart after the 2008 global financial crisis. KB Securities points out that such a decoupling is unusual for countries that share a currency and a common monetary policy.

KB Securities nonetheless does not foresee an immediate crisis. Yield spreads remain relatively contained despite the widening, and a larger risk could arise when the economic cycle turns down. In the previous crisis, spreads began broadening in 2008, but the stress became systemic only in the second half of 2011, after an economic slowdown had set in earlier that year.

This means the next economic downturn will serve as a pivotal test for European markets. When growth is healthy, investors may ignore fiscal frailties, yet a slowdown can push markets to reevaluate weaknesses and seek out the most vulnerable country, the report concludes.