European bond markets are experiencing a significant selloff, the steepest among major economies recently, driven by surging gas prices and escalating political risks. French, Italian, and UK longer-term borrowing costs have seen the largest increases in the G7 over the past month, with yields hitting multi-year highs. Even Germany, typically a safe haven, is not immune, as investors are demanding the highest compensation since 2011 to purchase its 30-year debt. German 10-year bund yields have climbed by 24 basis points from August 4, reaching approximately 3.35%, while comparable US Treasuries are up 14 basis points over the same period.
The primary driver of this market instability is the sharp increase in natural gas prices, which have surged over 120% since the Iran conflict began, reaching a three-year high last week. Europe is facing a critical energy situation, with gas storage levels at a record low for this time of year, significantly below the five-year average. As of September 1, European underground gas storage facilities were 65.4% full, compared to 77.4% a year ago, and well below the EU's 90% capacity target by winter. Analysts estimate that at the current refill rate, storage might only reach 70% to 75% capacity by the heating season, creating a risk of price spikes if there's a last-minute scramble to buy gas before winter.
This energy crisis is fueling fears that the European Central Bank will be compelled to maintain higher interest rates for longer than anticipated. A market-based gauge of euro-area inflation for the next 12 months has returned to levels last seen in May. Allianz SE's chief economist, Ludovic Subran, noted that rising inflation expectations have led investors to anticipate higher policy rates, thereby driving up longer-dated yields. More expensive gas translates to higher costs for electricity, heating, and industrial production, potentially leading to broader inflation across goods and services.
Geopolitical factors are exacerbating the situation. The renewed conflict between the United States and Iran, coupled with fears of escalation around the Strait of Hormuz, a crucial route for global energy supplies, is a key concern. This uncertainty is making liquefied natural gas (LNG) supplies harder to secure. The bond market selloff is also being influenced by political risks within Europe; France, for example, is seeing the extra yield investors demand for its bonds over German bunds near its widest since the 2012 euro area debt crisis, partly due to upcoming presidential elections and concerns about its debt load and deficit. In contrast, Italy's borrowing costs have narrowed against Germany's, as Prime Minister Giorgia Meloni is perceived to be bringing political stability and fiscal discipline.
While some investors like Steve Ryder of Aviva Investors and Kevin Zhao of UBS Asset Management are cautiously re-entering the market, buying European bonds and long-dated German notes, others like David Zahn of Franklin Templeton are waiting for German 10-year yields to reach closer to 3.5% before increasing their exposure. The sentiment is that global factors, including resilient US growth and heavy bond issuance, also contribute significantly to Europe's rising yields, making it challenging to predict when the upward trend will cease.
