The situation in Iran has driven up energy prices, leading to a rise in inflation expectations and one of the worst monthly sell-offs in Eurozone government bonds in nearly a decade. Borrowing costs in countries like Italy, France, and Spain have been pushed to multi-year highs, fueling market concerns that governments may be forced to increase fiscal spending to protect consumers.
Italy's 10-year government bond yield rose to 4.14% this month, reaching a new high since mid-2024. The yield has increased by approximately 0.8 percentage points this month, with the scale of the sell-off comparable to the previous energy crisis in 2022. France's 10-year yield touched nearly 3.9% intraday, its highest since 2009, while Spain's yield for the same maturity neared 3.7%, the first time since late 2023.
The 'Iran shock' has boosted oil and gas prices, raising inflation expectations, potentially forcing the European Central Bank to raise rates three times this year. Meanwhile, fiscal situations are deteriorating due to energy subsidy measures, exacerbating bond market sell-offs and causing a spiral of rising borrowing costs.
<h2>Inflation Fears Return, Central Bank Remains Cautious</h2>
According to the Financial Times, European Central Bank Executive Board member Isabel Schnabel stated on Friday that &#34;the ghost of inflation has returned&#34; and that this shift occurred faster than many expected. However, she also indicated that the ECB does not need to &#34;act in a hurry&#34; and still has &#34;time to watch the data&#34; for further evidence of second-round inflation effects.
Bert Colijn, an economist at ING, noted that the current rise in yields partly reflects investors unwinding positions that previously bet on a narrowing of interest rate spreads, particularly concerning Italy. He stated that significant concerns about Eurozone sovereign debt risk have not yet been observed but added, &#34;If the situation continues to worsen and the cost of fiscal measures keeps rising, this risk could still surface.&#34;
Tomasz Wieladek, Chief European Macro Strategist at T Rowe Price, commented: &#34;Investors are realizing that we are entering a scenario of low growth combined with high inflation, overlaid with more fiscal stimulus and expanding government spending.&#34;
<h2>Varying Responses from Countries</h2>
Faced with the energy price shock, Eurozone countries have responded with varying degrees of fiscal action, but most are broadly facing constraints on their available room for maneuver.
The Spanish parliament approved a 5 billion euro tax cut package on Thursday, reducing the value-added tax on electricity, natural gas, and fuel from 21% to 10%. This measure was proposed by left-wing Prime Minister Pedro Sánchez. Italy has temporarily cut fuel excise duties by 20% until April 7, at a cost of approximately 417 million euros, after which it will be reassessed. Rome plans to offset the loss in tax revenue by cutting spending in other areas, including healthcare.
France has chosen to maintain its fiscal discipline, refraining from large-scale energy subsidies. The French Prime Minister cited the fiscal deficit, projected to be as high as 5.1% of GDP by the end of 2025, as a reason why &#34;there is no piggy bank to draw from.&#34; The government has introduced targeted measures only for sectors heavily impacted, such as agriculture and trucking, at a cost of about 70 million euros in April.
Simone Tagliapietra, a Senior Fellow at Bruegel, pointed out that the measures announced so far by countries like Spain already indicate &#34;we are talking about significant sums of money.&#34; He warned, &#34;European governments face fiscal constraints and have many competing demands, especially defense spending, leaving very limited space in public budgets. I don't think there is the same large fiscal capacity as in 2022-2023.&#34;
<h2>Increased Budgetary Pressure, Narrower Buffer This Time</h2>
The previous energy crisis serves as a cautionary reference for the current situation. According to Bruegel data, since the energy crisis began in September 2021, European countries (including the UK and Norway) have collectively allocated and earmarked 651 billion euros to shield consumers from rising energy prices.
The OECD noted this week that many measures during the last crisis were &#34;poorly targeted and fiscally costly,&#34; warning that the measures taken this time to buffer energy price increases will &#34;further exacerbate the budgetary pressures currently faced by most governments.&#34;
Jean-François Robin, Global Head of Research at Natixis CIB, stated that investors are betting that the public finances of Eurozone countries &#34;will deteriorate&#34; as nations spend &#34;significant public funds&#34; to absorb the shock.
<h2>Yield Spread Advantage Reversed, Threshold Risks Emerge</h2>
This round of bond market sell-offs has led to a reversal of the yield spread advantage for highly indebted Eurozone members relative to Germany. For instance, Italy's 10-year bond spread over German Bunds, which was around 0.6 percentage points before the conflict erupted, has now widened back to nearly 1 percentage point.
Several investors emphasize that current spread levels are still moderate by historical standards – Italy's spread reached 3 percentage points during the pandemic. Konstantin Veit, a portfolio manager at bond giant PIMCO, said, &#34;The current widening of spreads does not negate the logic of long-term spread convergence,&#34; and pointed out that it would take years of high interest rates combined with low growth to truly question debt sustainability.
However, some analysts highlight key threshold risks: if German 10-year bond yields (currently around 3.1%) break above 3.5%, borrowing costs for Italy and France could be pushed towards 5%. T Rowe Price's Wieladek warned that at that point, &#34;debt sustainability will become uncertain.&#34;

L5EW

The 'Iran shock' has driven up energy prices, leading to the worst monthly sell-off in Eurozone government bonds in nearly a decade. Italy's 10-year yield rose to 4.14% (a new high since mid-2024), France reached 3.9% (its highest since 2009), and Spain neared 3.7% (the first time since late 2023). Spain announced a 5 billion euro tax cut, while Italy temporarily reduced fuel excise taxes, and France maintained its fiscal discipline without large-scale subsidies. Markets are concerned that rising inflation could force the ECB to raise rates three times, fiscal situations may worsen due to subsidies, and debt sustainability could be at risk

- The current energy crisis, exacerbated by tensions in Iran, has led to rising inflation expectations and significant sell-offs in European bonds, with borrowing costs reaching multi-year highs for countries like Italy, France, and Spain.  
- Italy's 10-year bond yield peaked at 4.14%, while Spain and France also saw yields rise sharply, prompting concerns about unsustainable fiscal measures amid limited governmental budgetary space.  
- Various countries are implementing differing fiscal responses, with Spain enacting tax cuts and Italy temporarily reducing fuel taxes, but analysts warn that budgetary pressures are intensifying and limit the scope for substantial financial intervention.

Wallstreetcn

"Iran Shock" Fuels Fears of Fiscal Deterioration as Eurozone Borrowing Costs Soar to Multi-Year Highs