European sovereign debt sounds the alarm, but the stock market remains resilient! French-German yield spread posts largest weekly rise in over 30 years; Deutsche Bank warns the divergence may not last

Zhitong Finance APP reports that significant pressure was observed in the European sovereign bond market last week, while European stock markets and corporate credit markets reacted mildly, creating a rare divergence between different asset classes. Deutsche Bank macro strategist Henry Allen pointed out that, compared to the past when risk spread across the European market, the current sharp widening of sovereign bond spreads without a significant drop in risk assets is “highly unusual.” Deutsche Bank believes this divergence is difficult to sustain for long; if recent financial pressures are not resolved quickly, European stocks and other risk assets may face increasing downward pressure.

France-Germany 10-Year Sovereign Bond Spread Sees Largest Weekly Rise in Over 30 Years

The volatility in the European sovereign bond market last week was particularly noteworthy. Data shows that the yield spread between French and German 10-year government bonds widened by 32 basis points in a single week, marking the largest weekly increase recorded by Bloomberg since German reunification in 1990, and pushing the France-Germany 10-year yield spread to its highest level since 2012. Meanwhile, the yield spread between Italian and German 10-year bonds also widened by 23 basis points, indicating that the pressure in the European sovereign bond market is not limited to France.

Sovereign bond yield spreads are typically seen as a key indicator reflecting market concerns about the fiscal and credit risks of different countries. German bonds have long been regarded as the benchmark asset for the Eurozone, so a rapid increase in the yield premium for countries such as France and Italy over German bonds means investors are demanding higher risk compensation.

Allen stated that last week’s developments in the European sovereign bond market were reminiscent of previous crises. During the 2011-2012 European debt crisis, March 2020, and the market turmoil in 2022, pressure in the sovereign bond market spilled over to other assets and European stocks typically experienced significant declines.

This time, however, other risk assets have responded much more moderately.

Severe Volatility in Sovereign Debt Market, While European Equity and Credit Markets Remain Stable

Despite the sharp widening of European sovereign bond spreads, the STOXX 600 Index fell by only 1.1% last week and remains less than 4% below its historical high. The European corporate credit market also did not show tension matching the sovereign bond market. As of last Friday, the Eurozone investment-grade corporate bond credit spread rose to 101 basis points, still significantly lower than levels seen during previous periods of market stress.

Allen noted that the simultaneous occurrence of a sharp widening of sovereign bond spreads, limited declines in equities, and only mild widening in corporate credit spreads is “highly unusual.” In other words, the European rates market and other risk assets are currently delivering starkly divergent signals regarding economic and financial prospects.

According to Deutsche Bank, looking at the performance of the sovereign bond market, the rates market has already started to price in the risk of contagion to other markets and the possibility of significant economic shocks; however, such pessimism has not been fully reflected in equity and corporate credit market pricing.

This divergence between asset classes also means that either the tense sentiment in the sovereign debt market dissipates quickly, or other risk assets may need to reprice to reflect the risks already evident in the rates market.

Market Divergence Unlikely to Persist, Risk Assets May Face Greater Pressure

Deutsche Bank believes that the current mispricing among different European asset classes is unlikely to last long. A relatively optimistic scenario would be for recent pressures in the sovereign bond market to subside quickly. Deutsche Bank compares this to market trends following the collapse of Silicon Valley Bank in March 2023—when financial markets experienced brief volatility, but stress dissipated relatively quickly and did not evolve into broader risk asset sell-offs.

However, if the current pressures in the European sovereign bond market do not reverse quickly, it may become increasingly difficult for risk assets such as stocks and corporate credit to maintain their current relative calm. This means that the key issue facing European markets is not just sovereign bond yields themselves, but whether the risk signals emitted by the bond market will ultimately spread to other asset classes.

During past market crises, a sharp widening of sovereign bond spreads usually coincided with declining investor risk appetite, falling stock prices, and widening corporate credit spreads. If the current tensions in the European bond market persist while equities remain near historical highs, the pricing gap between the two may further widen.

Deutsche Bank therefore warns that unless the financial stress observed over the past week dissipates quickly, European risk assets may face mounting pressure. The sovereign bond market has already begun to reflect the possibility of risk contagion and significant economic slowdown, while European equity and corporate credit markets have yet to react to the same extent.