European sovereign bonds sound the alarm, yet stock markets remain resilient! France-Germany spread posts largest weekly widening in over 30 years; Deutsche Bank warns the divergence may not last.

Title context: European sovereign bonds sound the alarm, yet stock markets remain resilient! France-Germany spread posts largest weekly widening in over 30 years; Deutsche Bank warns the divergence may not last. Text: European sovereign bond markets came under notable pressure last week, yet European equity markets and the corporate credit market reacted only mildly, forming a rare divergence across asset classes. Henry Allen, a macro strategist at Deutsche Bank, noted that compared with how European markets behaved during past episodes of risk contagion, the current sharp widening of sovereign bond spreads has not been accompanied by a major selloff in risk assets a situation he described as "very unusual." Deutsche Bank believes this divergence is unlikely to persist for long, and that if recent financial stress does not ease quickly, risk assets such as European equities could face growing downward pressure. France-Germany 10-year bond spread posts largest weekly widening in more than 30 years Last week's volatility in European sovereign bond markets drew particular attention. Data showed that the yield gap between French and German 10-year government bonds widened by 32 basis points in a week, the largest weekly increase in Bloomberg data going back to German reunification in 1990, pushing the France-Germany 10-year spread to its highest level since 2012. At the same time, the yield gap between Italian and German 10-year government bonds also widened by 23 basis points, indicating that pressure in Europe's sovereign bond market is not concentrated in France alone. Sovereign bond yield spreads are typically seen as an important gauge of market concerns about different countries' fiscal and credit risks. German government bonds have long been regarded as the benchmark asset of the euro area, so a rapid rise in the yield premium that France, Italy and other countries pay relative to German bunds means investors are demanding higher risk compensation. Allen noted that last week's moves in European sovereign bond markets were reminiscent of market behavior during several previous crises. During the 2011-2012 euro debt crisis, March 2020 and the market turmoil of 2022, pressure in sovereign bond markets spread to other assets while European equities also typically fell sharply. This time, however, the reaction in other risk assets has been noticeably milder. Sovereign bond markets in sharp turmoil, while European equities and credit markets remain relatively calm Despite the sharp widening of European sovereign bond spreads, the pan-European Stoxx 600 fell only 1.1% last week and remains less than 4% below its record high. Europe's corporate credit market has likewise failed to show a level of tension matching that in the sovereign bond market. As of last Friday, the credit spread on euro-area investment-grade corporate bonds had risen to 101 basis points, but that was still well below levels seen during past periods of market stress. Allen said the combination of a sharp widening in sovereign bond spreads, only limited declines in stock markets and only a modest widening in corporate credit spreads is "very unusual." In other words, Europe's rates market and other risk assets are currently sending clearly divergent signals about the economic and financial outlook. Deutsche Bank believes that, judging by the performance of the sovereign bond market, the rates market has already begun to price in the possibility of risk spreading to other markets and a significant hit to economic growth; but similar pessimistic expectations have not yet been fully reflected in equity and corporate credit market pricing. This divergence across assets also means that either the tension in the sovereign bond market will quickly fade, or other risk assets may need to reprice to reflect the risks already reflected in the rates market. Market divergence unlikely to last; risk assets may face greater pressure Deutsche Bank believes the current pricing mismatch across European asset classes is unlikely to persist for long. In a relatively optimistic scenario, recent sovereign bond market stress eases quickly. Deutsche Bank compared this with market behavior after the collapse of Silicon Valley Bank in March 2023 at the time, financial markets were briefly in severe turmoil, but the pressure soon faded and did not develop into a broader selloff in risk assets. However, if the recent pressure in Europe's sovereign bond market cannot be reversed quickly, risk assets such as equities and corporate credit may find it increasingly difficult to maintain their current relatively calm performance. That means the key question facing European markets now is not just sovereign bond yields themselves, but whether the risk signals sent by the bond market will ultimately transmit to other asset classes. In past market crises, a sharp widening of sovereign bond spreads was usually accompanied by a decline in investors' risk appetite, falling stock prices and wider corporate credit spreads. If the current tension in Europe's bond market persists while stocks remain near record highs, the pricing gap between the two could widen further. Deutsche Bank therefore warns that unless the financial stress seen over the past week eases quickly, European risk assets could come under increasing pressure. The sovereign bond market has already begun to reflect the possibility of risk contagion and a marked hit to economic growth, while European equities and the corporate credit market have yet to respond to the same degree.