After the historic sell-off in European government bonds last week, many strategists and managers are wondering whether things will ever be the same again. That a change from the recent history of bond markets is underway is evidenced by the fact that yields in the euro area are rising, while yields on US Treasuries are falling. And as prices move in the opposite direction to yields, those of Bunds, BTPs, and other euro bonds have been falling, while overseas they have been rising.
To get their bearings, investors need to pay attention to what is moving government bond prices and yields in Europe and the US:
1) In the eurozone, yields are rising on expectations of increased government bond issuance after the end of the German “debt brake.” In addition, markets expect that other continental governments will also have to increase defense spending, in a context where some of them, such as France and Italy, are struggling to balance budgets.
2) In the US, yields are falling because there are “growing and justified concerns about growth and economic stability,” says Dominic Pappalardo, chief multi-asset strategist at Morningstar Investment Management, who also points out that many investors are shifting to a “risk-off” stance after sharp declines in the stock market. Persistent inflation, however," Pappalardo adds, “could curb further declines in US Treasury yields. Indeed, the yield curve is steepening because “long-term rates [more sensitive to high inflation] have not fallen as quickly as short-term rates.”
How Much do BTPs, Bunds, and US Treasuries Yield?
Yields on German Bunds, the benchmark government bonds for the euro area and considered risk-free, rose last week after the incoming chancellor, Friedrich Merz, announced that Germany will increase defense spending and release fiscal policy from government debt limits. This move had an impact on the yields of eurozone government bonds, including BTPs, with consistent selling in bond markets.
“On Tuesday [March 4], Merz announced a dramatic change in fiscal policy, paving the way for the gap between US and European rates to converge,” Flavio Carpenzano, fixed income investment director at Capital Group, tells Morningstar. “The market reaction was swift and decisive: on Wednesday [March 5], German Bund yields rose 30 basis points, dramatically redetermining the spread between US 10-year and German 10-year yields.”
As of now, Germany’s 10-year Bund yields 2.9%, having approaced 3% in recent days, up from 2.38% at the end of February. The Italian BTP of the same maturity has a yield of 3.9%, up from 3.47% at the end of last month. The spread, i.e., the differential between the two bonds, is around 107 basis points and has remained quite narrow from historical levels, signifying that German fiscal stimulus could have a positive impact on Italian growth.
After the historic collapse in European government bond prices--and the rise in yields--there could be a period of volatility in the short term, according to Florian Spaete, senior bond strategist at Generali Investments, who does not rule out new spikes in the Bund yield to 3%, although over the course of the year “the German 10-year is expected to be between 2.4% and 2.7%.”
Despite recent movements, government bond yields in the eurozone remain lower than those of the 10-year US Treasury (4.3%).
ECB-US Fed: Divergent Monetary Policies
The movement of the German Bund should be placed in the broader context of the current phase of monetary policy. On March 6, the European Central Bank cut interest rates by 25 basis points, as widely expected by markets, bringing the deposit rate to 2.5%. From June 2024 to the present, the ECB has cut benchmark rates six times, bringing them down from 4% to the current level.
By contrast, in the US, the Federal Reserve reduced federal funds only three times in 2024, bringing them into the 4.25%-4.50% range from 5.25%-5.50%. The first cut occurred in September, which was followed by two more in November and December. As a result, rates are currently higher in the US than in the eurozone.
Defense Spending and Recession Risks: The Impact on Government Bonds
Markets are looking not only at the situation in the euro area, but at the economic and financial outlook on both sides of the Atlantic. With this in mind, investors need to assess the impact of tariffs announced by US President Donald Trump, increased defense spending in Europe, and possible peace in Ukraine.
The US economy has so far been more resilient than that of the euro area, with US gross domestic product growing 2.3% year-on-year in the fourth quarter, while on this side of the ocean it rose 0.2%. But the future outlook is clouded by tariffs on major trading partners, threatened or already put in place by Trump, and the impact they could have on inflation, as well as employment. On the latter front, the impacts of the federal government’s massive job cuts have not yet become apparent.
While the Federal Reserve may still leave rates unchanged in the coming months in the face of inflation far from the 2% target; it may have to reduce the cost of money to support the economy. This assumption should not be ruled out entirely after Trump’s statements in recent days about the possibility of a recession in the US.
In any case, bond futures markets see a 97% chance that the central bank will keep rates firm in the current 4.25%-4.50% range at its March 19 meeting.
The “New” Risks to the Eurozone
In the eurozone, the ECB revised growth forecasts downward and inflation forecasts upward at its last meeting on March 6, but it also changed the focus of its speech, declaring that monetary policy is becoming “significantly less restrictive,” meaning that the end of the easing phase is approaching.
In essence, the ECB faces three new risks:
1) Inflation: the impact of increased defense spending in Germany and the European Union is not yet fully considered in current forecasts.
2) US tariffs: on the one hand, they could negatively impact growth, requiring further rate cuts to support the economy; on the other hand, they could overheat it by prompting the Frankfurt institution to raise the cost of money.
3) Markets' expectations: “Investors still have 40 basis points of cuts priced in by year-end, but the ECB’s new language sends a clear signal that the institution may stop sooner than expected,” says Carlo De Luca, Gamma Capital Markets chief investment officer.
What Does This Mean for Investors in Government Bonds?
Over the past week, investors in euro government bonds, including Italian BTPs, have experienced losses due to falling prices caused by the sudden and sharp rise in yields. Looking ahead, however, eurozone bond investors may benefit from more attractive yield expectations on local government bonds. “As yields have risen substantially, the potential for income generation has also improved,” explains Morningstar’s Pappalardo. “In addition, European fixed income can now offer greater benefits than equity exposure when it comes to offsetting risk, as there is room for yields to fall (and prices to rise) if a downturn in the stock market were to occur.”
The situation is opposite in the US, where investors have seen positive returns from Treasuries in recent weeks as yields have fallen, which, says Pappalardo, “has been critically important for investors with diversified portfolios, as it has provided some offset to the significant decline in the stock market.”
Where to Look for Yield in Government Bonds
These opposing trends on both sides of the Atlantic are causing a historic shift in investors' choices. “Some are switching from US Treasuries to euro bonds to get the higher yields now available. This is somewhat the opposite of recent history, as US rates had been significantly higher than euro rates, forcing investors to put capital into US Treasuries at the expense of euro bonds,” adds the Morningstar strategist.
However, Nicolò Bragazza, associate portfolio manager at Morningstar Investment Management, recalls the importance of US Treasuries as a “haven in times of financial market stress.” These bonds “remain attractive instruments to increase portfolio diversification, despite the strong uncertainty hovering over the Trump administration’s trade and fiscal policies,” says Bragazza, who also stresses the importance for a European investor to decide whether or not to hedge the euro/dollar exchange rate, “as it represents an additional risk factor that can significantly change the risk and return profile of the investment.”
What’s the Outlook for Government Bond Markets?
The outlook in bond markets remains somewhat uncertain in both the eurozone and the US.
“We expect that the yield curve in Europe will see a steepening in anticipation of increased issuance to finance the new fiscal policy,” says Capital Group’s Carpenzano, who also notes that the euro has strengthened since the announcement of the incoming German chancellor, “but its future path depends on the ability of the fiscal push to overcome the possible drag of potential tariffs.”
In the US, Carpenzano expects the yield curve to become steeper, “against the uncertain backdrop of a potential economic slowdown or growing concerns about debt.” This scenario could have further negative impacts on the dollar, which has already been hurt in recent weeks by the contradictory news flow on tariffs.
The euro/dollar exchange rate is a variable that investors who want exposure to US government bonds must take into account. If the euro continues to strengthen against the dollar, after touching 1.09 in the last week, hedging the exchange rate risk may be necessary to avoid nullifying the effects of bond diversification.
However, some are throwing water on the fire. For Matteo Ramenghi, chief investment officer of UBS WM in Italy, the potential for further strengthening of the euro is “limited.” Conversely, “a retreat” is likely, given the threat of US tariffs.
The author or authors do not own shares in any securities mentioned in this article. Find out about Morningstar's editorial policies.
