Bond Bulls Bet Europe’s Answer to War Is a Tighter Fiscal Union

(Bloomberg) -- One of the most spectacular European bond rallies in years may have room to run amid speculation euro-area governments will forge a tighter fiscal union to shield their economies from the spillovers of war at their doorstep.

At a time when the European Central Bank is growing more reticent to exit stimulus, the prospect of more bonds issued by the European Union rather than member states could help drive down borrowing costs. German 10-year yields dropped 30 basis points this week, their biggest decline in more than a decade, matching a slide in Italian notes.

It's still early days and clearly a broader flight-to-quality is at play. Yet there's a palpable shift in thinking after Germany announced plans for a massive boost in its defense budget in response to Russia's invasion of Ukraine, breaking with its traditional spendthrift stance. Italian Prime Minister Mario Draghi then called for such spending to pooled at the EU level.

Russian Invasion Pushes Europe Into New Era of Big Spending

“Markets are wasting no time in internalizing the seismic change in Europe,” said Michael Leister, Commerzbank's head of interest-rate strategy. They are pricing that “European solidarity will reach another level,” he said.

Strategists at Citigroup Inc., RBC Capital Markets and Commerzbank AG are all pointing to effect the speculation is having on the region's debt markets. More burden sharing would build off the success of joint-EU bond sales under Europe's NextGenerationEU program, or NGEU, a breakthrough triggered by the pandemic crisis that was integral in keeping economies afloat.

New Dynamic

That's helping keep the premium investors demand to hold Italian debt -- one of the region's most indebted economies -- over German securities in check despite the risk-off tone in markets as the war escalates. The spread widened less than one basis point in the week to 1.61%.

“The Ukraine war fundamentally changes the dynamic in the EU and changes the ECB reaction function,” said Peter Schaffrik, global macro strategist at RBC. He expects military and energy spending to be ramped up “for years” and wouldn't rule out talks to start soon on extending the NGEU to defense and energy policy.

Reduced political risk, increased public spending plans and the slower end to ECB stimulus should all support European peripheral spreads, he added.

The region now faces new security threats form the Ukraine war as well as a disruption to key commodities that could fan inflation already running a record pace. The EU depends on Moscow for roughly 40% of its gas imports.

War Brings EU Closer to Suspending Fiscal Rule Again for 2023

Against this backdrop, a string of ECB officials has signaled they could delay unwinding stimulus given the headwinds to economic growth. That would be a windfall for the bloc's weakest states, including Italy and Greece, that benefit greatly from the bank's bond purchases.

Traders this week have gone back and forth between seeing a quarter-point ECB rate increase this year, or next. That's a far cry from a couple weeks ago, when they were all but certain policy makers would deliver such a hike by September.

German 10-year yields fell nine basis points on Friday to minus 0.07%. Equivalent Italian rates edged three basis points lower to 1.54%.

Spending Spree

Some economists say a shortage of collateral may have exacerbated this week's moves. Positioning also likely compounded the rally as the sheer momentum flushed out traders betting on declines. There's also the bleak economic outlook that tends to lift bond prices.

Still, others remain convinced there are more fundamental changes afoot. RBC's Schaffrik argues that the war in Ukraine will unify member states and reduce the appeal of right wing and anti-EU platforms, such as those in France and Italy, that tend to cast doubt on the viability of the project.

For Commerzbank's Leister the impetus for the EU to band together is almost existential. “While EU countries protect the borders, the ECB protects favorable funding conditions for the upcoming public spending spree.”

Next Week

The European Central Bank's rate decision is on March 10. Economists surveyed by Bloomberg expect the ECB to offer no firm commitments on withdrawing stimulus
Euro-area sovereign supply should moderate to about EU15bn, according to Commerzbank. Germany, the Netherlands, Austria, Ireland, Italy are lining up auctions