The yield on US and European debt soars due to aggressiveness of central banks

The markets have ended up accepting the new mantra that central bankers have been chanting loudly since the summer: interest rates will have to stay higher for longer to quell inflation. Those three words, “higher for longer,” have finally made an impact among investors, who are demanding more profitability to buy public debt. The pressure has led the U.S. Treasury 30-year bond to offer a yield of almost 5%, the highest since 2007. Tensions in debt markets have also reached the euro zone, with the German ten-year bond, the euro area’s benchmark, yielding 3%, the highest since 2011.

Just a year and a half ago, investors still had to pay to buy ten-year German bonds. It was in the spring of 2022 when these obligations, considered the safest in Europe, left the red numbers behind and put an end to an era in which some banks in the euro zone came to have negative-interest mortgages and charge clients for their money deposits. Then began what analysts considered the path towards normalization: savers had to be rewarded again and debtors had to be penalized again.

The path has ended up being fast: this week, the German ten-year bond yield reached 3%. It did so even as U.S. debt reached levels unseen since 2007, in the early days of the financial crisis. The reason is the tightening of monetary policy, which everything indicates will be more severe than expected. “The process of rising interest on debt is due to the fact that the normalization of monetary policy will also be transferred to the bonds of each country. And secondly, the fears that everything the Federal Reserve and the ECB have done will not be enough to put an end to high inflation,” says Santiago Carbó, a professor at the University of Valencia.

In the first half of the year, the markets assumed that the cycle of increases in Washington and Frankfurt was already over and that, once the economy entered a recession, interest rates would begin to fall as early as the beginning of next year. The economies of the U.S. and the euro zone, however, have not been depressed so far. What’s more, labor markets remain strong and wages have maintained their upward path, leading investors to conclude that central bankers will keep their word and continue raising rates into territory that cools the economy. “Bond markets were wrong when they believed that the U.S. economy would contract this year and that the Federal Reserve would be forced to stop raising and start lowering the price of money sooner rather than later. Now the markets have overreacted,” explains José Carlos Díez, a professor of economics at the University of Alcalá in Spain.

Sell orders

The heating bond market in the U.S., which calmed down somewhat this Wednesday after the publication of weaker than expected employment data, has quickly spread to Europe. In part, because massive debt issues are also due to technical factors. “The main reason is the scenario of higher interest rates for a longer time. We have seen how there are members of the Federal Reserve board who even believe that there could be new increases this year,” explains Javier Pino, an analyst at the consultancy AFI. “But there are also technical patterns, since, at a certain level, there are investors who may have closed positions,” he adds. That is, sell orders are placed after the bonds exceed certain levels.

In Germany, the yield on the German bond exceeded 3%, reaching a level that had not been seen since 2011. The yield on other countries’ debt also rose: France’s exceeded 3.5%; Portugal’s reached 3.6%, and Spain’s soared to 4%. The good news is that the yield spread remains at bay, around 110 basis points with respect to the German bond. On the other hand, Italy’s 10-year government bond yield practically reached 5%, with a credit spread that exceeds 200 basis points due to the markets’ distrust of Giorgia Meloni’s policies. As Rome’s financial forecasts become known, investors fear budgetary deviations that could end in a confrontation with Brussels. “Markets ultimately punish heterodoxy. We saw it in the United Kingdom and we see it now in Italy,” says Carbó.

The Italian yield spread is still very far from the 500 basis points that caused the departure of former prime minister Silvio Belusconi in 2011. “It has not yet reached that point, but it is close to the 225 basis points that the European Central Bank considers an uncomfortable level for the transmission of monetary policy,” says Javier Pino, from AFI, noting that Frankfurt has already armed itself with the Transmission Protection Instrument (TPI), which allows bond purchases of individual EU countries in the event of abnormal interest rate hikes. In fact, the markets began to lose patience even before the first rise, in July 2022, and punished the debt of peripheral countries at the beginning of summer. Frankfurt then decided to come to the rescue with an instrument, the TPI, which for now it has not had to use but whose mere existence has already calmed the markets. However, the question marks generated by Meloni have ended up harming Rome again. “It is good news that Spain is decoupled from Italy,” adds José Carlos Díez.

The markets, however, are especially focused on U.S. debt. And the rise in the country’s bond yield once again made the dollar appreciate against the euro. In fact, the European currency once again moved closer to parity by falling below $1.05, although it ended up recovering that level. The turbulence has also spread to the stock markets. Analysts expect that, after these movements, debt markets will stabilize. However, they do anticipate that they will put pressure on central bankers, especially in Frankfurt, to keep interest rates frozen.

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