What is driving Europe’s yield decoupling?

 A growing divergence in European government bond yields is raising a hidden risk for financial markets, with borrowing costs in major Western European economies climbing toward levels last seen nearly two decades ago, KB Securities said. 

Ten-year government bond yields in major Western European countries have already moved above their 2023 peaks and are approaching their 2007 highs, while the U.S. 10-year Treasury yield, although above 4.8%, remains below its 2023 peak, according to the note.

The more important concern is the widening gap between Western and Southern Europe. Yields in France and Germany have risen sharply, while those in Spain and Italy remain below their 2023 peaks and have increased at a more moderate pace. KB Securities said the divergence is notable because the countries share the euro and operate under the same monetary policy set by the European Central Bank.

Fiscal positions help explain the difference. France and Germany are expected to run budget deficits of about 5% to 6% of GDP next year, compared with projected deficits of 2% to 3% for Spain and Italy, keeping the latter broadly within the European Union's 3% fiscal-deficit threshold. Germany is also expected to increase borrowing to finance defence and infrastructure spending, while France has struggled to sustain fiscal-tightening measures amid political and public opposition.

The divergence echoes the period before the 2011 euro zone sovereign debt crisis, when government bond yields across member states began moving apart following the 2008 global financial crisis. KB Securities noted that such divergence is unusual among countries sharing a currency and a common monetary policy.

Still, the brokerage does not see an imminent crisis. Yield spreads remain relatively narrow despite widening, and the bigger risk could emerge when the economic cycle turns lower, it said. During the previous crisis, spreads began widening as early as 2008 but the situation did not escalate into a systemic crisis until the second half of 2011, after an economic slowdown had begun earlier that year.

That makes the next economic downturn a key test for European markets. When growth is strong, investors can overlook fiscal weaknesses, but a slowdown can prompt markets to reassess vulnerabilities and search for the weakest link, the report said.