On Thursday, the Eurozone bond market experienced a typical "event-driven upsurge—rational pullback" process. The yield on Germany's 10-year government bond fell from an intraday high of 3.05% to 2.99%, with the weekly trend expected to turn downward. Germany's 2-year yield remained at 2.61%, while the yield on Italy's 10-year government bond closed around 3.869%. The main market focus continues to be news related to the Iran conflict. However, differing from previous days when inflation and interest rate expectations were directly amplified, investors are now more focused on the potential restoration of energy transportation, the decline in risk premiums, and position management ahead of the long weekend.
Key Variables in Market Reassessment
The core of this Euro bond market fluctuation is the dual impact of the Middle East situation on inflation expectations and policy rate predictions in Europe. After Trump's more aggressive military statements, the market briefly priced in a stronger tightening path, with yields initially rising significantly. However, as it became apparent that the situation was not escalating unilaterally, and the potential reopening of the Strait of Hormuz was taken into account, the rise in yields quickly reversed. On a weekly basis, Germany's 10-year government bond yield is expected to drop by 10 basis points, indicating that the bond market has begun correcting the previous overly tense pricing.
Competitive Landscape
Within the Eurozone, the performance difference between core and non-core bonds remains notable. German bonds continue to act as a pricing anchor for the region, while peripheral markets like Italy and France face higher risk premiums. Currently, the yield spread between Italy's 10-year bond and comparable German bonds is 86 basis points, narrowed from nearly 100 basis points last week, yet still significantly higher than the pre-conflict level of 63 basis points. The French and German 10-year bond spread has also widened from 58 to 70 basis points. In other words, even if interest rates decline in the short term, the credit and fiscal divergence within the Eurozone has not disappeared, and peripheral countries' financing environments remain more fragile than that of the core areas.
Policy Expectations and Financial Stability
The money market continues to price in at least two 25-basis-point interest rate hikes by the European Central Bank, with the probability of a third hike around 80%. This marks a slight decline from this week's high but indicates a tighter policy outlook compared to pre-conflict rate cut expectations. Panetta emphasized that the energy market's tension caused by the Middle East conflict could impact financial stability, highlighting the ECB’s concern not just with inflation, but also with asset price volatility, rising financing costs, and the potential impact on the fragile sovereign bond market. For bond market investors, any marginal shifts in the ECB’s balance between "stability" and "inflation" will determine whether future peripheral spreads can remain under control.
Future Observation Points
HSBC believes that by the end of the second quarter, the yield spread between Italy and Germany’s 10-year bonds may remain at 100 basis points, and could widen to 140 basis points in an adverse scenario. This assessment suggests the market is still allowing for stress testing scenarios involving geopolitical escalation, further oil price increases, and deteriorating risk appetite. If progress in energy transportation restoration is smooth, German bond yields may continue to decline moderately; however, if the conflict once again drives up energy prices, peripheral bonds, especially Italian government bonds, may come under renewed pressure, potentially reigniting discussions on ECB intervention tools.
