"Iran Shock" Raises Concerns Over Fiscal Deterioration, Eurozone Borrowing Costs Surge to Multi-Year Highs

The situation in Iran is driving up energy prices, inflation expectations are rising, and eurozone government bonds have recorded one of the worst monthly sell-offs in nearly a decade. The borrowing costs for countries such as Italy, France, and Spain have been pushed to multi-year highs, and concerns are growing that governments will be forced to increase fiscal spending to protect consumers.

The yield on Italy’s 10-year government bonds soared to 4.14% earlier this month, reaching a new high since mid-2024, with an increase of about 0.8 percentage points this month, comparable to the scale of the sell-off during the last energy crisis in 2022. The yield on France’s 10-year bonds touched nearly 3.9%, the highest since 2009; Spain’s yield approached 3.7%, the first time since the end of 2023.

The Iranian shock has driven up oil and gas prices, inflation expectations are warming, and the European Central Bank may be forced to raise interest rates three times this year; meanwhile, countries’ finances are deteriorating due to energy subsidy measures, exacerbating the bond market sell-off and causing borrowing costs to spiral upward.

The shadow of inflation returns, central bank stance cautious

According to the Financial Times, Isabel Schnabel, a member of the European Central Bank’s executive board, stated in a speech on Friday that “the ghost of inflation has returned,” and the speed of this change has exceeded what “many” expected. However, she also indicated that the ECB does not need to “rush to act,” as there is still “time to observe the data” and wait for further evidence of second-round inflation effects.

Bert Colijn, an economist at ING, noted that the current rise in yields partly reflects investors closing out previous positions betting on narrowing spreads, particularly focused on Italy. He stated that there is currently no significant market concern about eurozone sovereign debt risks, but “if the situation continues to deteriorate and the costs of fiscal measures rise further, this risk may surface.”

Tomasz Wieladek, Chief European Macro Strategist at T Rowe Price, stated: “Investors are realizing that we are entering a combination of low growth and high inflation, coupled with more fiscal stimulus and government spending expansion.”

Countries respond with varying degrees of strength

In the face of the energy price shock, eurozone countries are responding with varying degrees of strength, but generally face the dilemma of limited space.

The Spanish parliament approved a €5 billion tax reduction plan on Thursday, lowering the VAT rate on electricity, natural gas, and fuels from 21% to 10%. This plan was proposed by left-wing Prime Minister Pedro Sánchez. Italy temporarily reduced fuel consumption taxes by 20%, a measure lasting until April 7, with a cost of about €417 million, at which point it will be evaluated. Rome plans to offset the tax revenue loss by cutting spending in other areas, including healthcare.

France has chosen to maintain its fiscal baseline and has not launched large-scale energy subsidies. French Prime Minister cited a projected fiscal deficit of 5.1% of GDP by the end of 2025, stating that “there is no savings jar to tap into.” The government has only rolled out targeted measures for heavily impacted sectors such as agriculture and truck transport, with April costs around €70 million.

Simone Tagliapietra, a senior researcher at Bruegel, pointed out that the measures announced so far by countries like Spain indicate that “we are talking about large sums of money.” He warned: “European governments face fiscal constraints, with significant competing demands, particularly for defense spending, and the public budget space is very limited. I don’t believe there is the fiscal space for large-scale interventions like we saw in 2022 to 2023.”

Budget pressure intensifies, this round of buffering has less space

The previous energy crisis provides a cautionary reference for the current situation. According to Bruegel data, since the energy crisis erupted in September 2021, European countries (including the UK and Norway) have allocated and reserved a total of €651 billion to protect consumers from the impact of rising energy prices.

The OECD pointed out this week that many of the response measures during the last crisis were “insufficiently targeted and had significant fiscal costs,” warning that the measures taken this time to buffer against rising energy prices will “further exacerbate the budget pressures faced by most governments.”

Jean-François Robin, global research head at Natixis CIB, stated that investors are betting that public finances in eurozone countries “will deteriorate,” as countries are spending “large amounts of public funds” to absorb this shock.

Spread advantages reverse, threshold risks emerge

This round of bond market sell-offs has caused the spread advantage of high-debt eurozone member countries relative to Germany to reverse. For Italy, for example, the yield spread of its 10-year bonds relative to German bonds was about 0.6 percentage points before the conflict erupted, and it has now risen to nearly 1 percentage point.

Several investors emphasized that current spread levels are still moderate from a historical perspective—Italy’s spread once reached 3 percentage points during the pandemic. Konstantin Veit, a portfolio manager at bond giant Pimco, stated, “The current widening of spreads does not negate the logic of long-term narrowing of spreads,” and noted that it would take several years of high rates and low growth to truly raise questions about debt sustainability.

However, some analysts are warning of key threshold risks: if the yield on Germany’s 10-year government bonds (currently around 3.1%) rises above 3.5%, borrowing costs for Italy and France will be pushed towards 5%. T Rowe Price’s Wieladek warned that at that point, “debt sustainability will become uncertain.”

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