The Spread Between Germany And Italy Is Sparking A New Worry

The Spread Between Germany And Italy Is Sparking A New Worry
Luke Suddards

over 1 year ago2 mins

The chart shows the BTP-bund spread over the past ten years – in other words, it’s the difference in the yield offered by Italy’s 10-year government bonds (BTP) and Germany’s 10-year bonds (or “bunds”). You may be wondering: why Germany and Italy? Well, the bund is the benchmark rate across Europe, because Germany is considered its most stable country from a political and economic perspective. Italy, on the other hand, is considered among the euro zone’s riskier countries, with higher debt loads and less political stability. Bond traders use the BTP-bund spread as a risk gauge for the euro zone. This week, the spread rose above the psychologically significant 2.5% mark, close to levels not seen since the peak of the Covid crisis, and that put bond investors on alert. It then dipped back below 2.3%, on news that Germany would support the issuance of joint EU debt, easing some worries about Italy. Just a few hours later, the German government rejected the report, causing yo-yo-style price volatility and bringing the spread to just shy of 2.4% as of writing.

Bottom line: investors are clearly concerned about fiscal largesse and debt sustainability – looking at you, Britain – and as a result, they’re demanding additional compensation through higher interest rates. Italy will be submitting its draft budget to the European Commision this week and there are fears that the newly elected center-right coalition plans to open the spending taps. If the budget is interpreted as too expansionary, that’s probably going to push yields on the BTPs even higher, because investors will worry about Italy’s ability to finance the growing debt load. And it’s likely also to give a fresh headache to the European Central Bank (ECB).

This is the No. 1 challenge for the ECB: trying to set interest rates for 19 different countries. It has to gauge the right level of hikes, based on varying levels of inflation, and try not to spark a crippling recession or a debt crisis in the process. But there are so-called bond vigilantes in the market too: traders who will sell bonds, pushing up yields to protest what they see as inflationary monetary and fiscal policies. And if they sense fragilities in the market, such as the prospect for a debt crisis, they’ll be out for blood.

With all this in play, you could consider buying the safe-haven Swiss franc against the euro, which tends to decline when the BTP-bund spread rises as euro-zone sentiment sours. Or alternatively, the Lyxor EuroMTS 10Y Italy BTP Government Bond ETF (ticker: BTP10; expense ratio: 0.165%). As yields increase the price of the ETF would decline and vice versa.

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