European sovereign bond markets came under notable pressure last week, yet European equity markets and the corporate credit market showed little reaction, creating a rare divergence across different asset classes.

Deutsche Bank macro strategist Henry Allen pointed out that compared with past episodes when risk contagion emerged in European markets, 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 over the long term, and if recent financial stress does not ease quickly, risk assets such as European equities could face increasing downward pressure.

French-German 10-Year Bond Spread Posts Biggest Weekly Widening in Over 30 Years

Last week's turbulence in the European sovereign bond market was particularly noteworthy. Data showed that the yield gap between French and German 10-year government bonds widened by 32 basis points in a single week, marking the largest weekly increase since Bloomberg began recording data following German reunification in 1990, and pushing the French-German 10-year bond 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 the European sovereign bond market is not concentrated solely on France.

Sovereign bond yield spreads are typically regarded as an important gauge of market concerns about the fiscal and credit risks of different countries. German government bonds have long been viewed as the benchmark asset of the eurozone, so the rapid rise in yield premiums of countries such as France and Italy relative to German bunds means investors are demanding higher risk compensation.

Allen noted that last week's moves in the European sovereign bond market were reminiscent of market behavior during several previous crises. During the 2011-2012 European debt crisis, March 2020, and the market turmoil of 2022, sovereign bond market stress spread to other assets while European equities typically also suffered significant declines.

But this time, the reaction in other risk assets has been notably more muted.

Sovereign Bond Market in Turmoil While European Equities and Credit Markets Remain Relatively Stable

Despite the sharp widening of European sovereign bond spreads, the European Stoxx 600 index fell only 1.1% last week and remains less than 4% below its all-time high. The European corporate credit market has likewise failed to show a level of tension matching that of the sovereign bond market.

As of last Friday, eurozone investment-grade corporate bond credit spreads had risen to 101 basis points, but this remains significantly below levels seen during previous periods of market stress.

Allen said the simultaneous occurrence of sharply wider sovereign bond spreads, limited equity market declines, and only modestly wider corporate credit spreads is "very unusual." In other words, European rate markets and other risk assets are currently giving clearly divergent signals about the economic and financial outlook.

Deutsche Bank believes that, judging from the performance of the sovereign bond market, the rates market has already begun to price in the possibility of risk contagion to other markets and a significant hit to economic growth. However, similar pessimistic expectations have not yet been fully reflected in the pricing of equity and corporate credit markets.

This divergence across assets also means that either the tension in the sovereign bond market will quickly subside, or other risk assets may need to reprice to reflect the risks already embedded in the rates market.

Market Divergence Unsustainable; Risk Assets May Face Greater Pressure

Deutsche Bank believes the current pricing misalignment across different European asset classes is unlikely to persist for long. In a relatively optimistic scenario, recent sovereign bond market stress eases rapidly. Deutsche Bank draws an analogy with market behavior after the collapse of Silicon Valley Bank in March 2023 — financial markets were briefly in turmoil, but the stress subsided fairly quickly and did not evolve into a broader selloff in risk assets.

However, if the recent pressure in the European sovereign bond market cannot be quickly reversed, risk assets such as equities and corporate credit may find it increasingly difficult to sustain their current relatively calm performance.

This means the key question facing European markets is not merely sovereign bond yields themselves, but whether the risk signals emanating from the bond market will ultimately transmit to other asset classes. In previous market crises, a sharp widening of sovereign bond spreads was typically accompanied by declining investor risk appetite, falling equity prices, and widening corporate credit spreads. If the current tension in the European bond market persists while equities 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 significant shock to economic growth, while European equities and the corporate credit market have yet to respond to the same degree.