Key Takeaways
- Eurozone government bond prices have been volatile in the first half the year.
- Plans to increase defense spending in Europe will raise government spending.
- The “flight to quality” may favor government bonds over the stock market.
Tariffs Drive Money Into European Debt
After a volatile first half of the year in government bond markets, the summer poses new challenges for eurozone investors amid heightened geopolitical risks and unpredictable trade war developments.
The Morningstar Eurozone Treasury Bond Index, which measures the performance of euro government bonds with a maturity of more than a year, was up 0.62% in the first six months of the year, amid strong selling that drove prices down and yields up in January and again in March after the announcement of the end of the “debt brake” in Germany.
In April, the shock of universal tariffs unveiled by US President Donald Trump sent US Treasury prices plummeting and triggered investor movement into European government bonds, particularly the German Bund, reversing previous trends. Now bond managers are focused on widespread uncertainty in the third quarter.
What Factors Will Drive Government Bond Prices in Q3?
For Morningstar’s chief multi-asset strategist Dominic Pappalardo, inflation and fiscal policy decisions will most likely be the main determinants of eurozone government bond yields.
“Eurozone bond yields remain relatively elevated compared with the last few years, although all countries are below their recent highs,” Pappalardo says, adding that investors “should consider adding exposure there, particularly where a yield advantage over US Treasuries may exist.”
Some of the factors that drove the euro government bond market in the first half the year will also be in place, but there are also new ones to consider:
- Developments in the Middle East and the impact on oil and gas exports.
- The evolution of the trade war.
- Fiscal risks due to increased defense spending and the end of constraints on government borrowing restraint in Germany.
- The European Central Bank’s future decisions on interest rates.
Why Government Bonds May Be Favored Over Equities
“Investing in government bonds can play the traditional role of portfolio diversification by reducing overall risk, especially in situations of stock market declines, which generally produce the 'flight to quality' effect,“ says Massimo Spagnol, fixed income portfolio manager at Generali Asset Management.
The stock market is more exposed to a correction if economic risks related to tariffs or rising oil prices materialize, affecting inflation. This is why Chris Iggo, chief investment officer at Axa IM Core, believes that the summer could favor bond market performance.
“There are a whole range of reasons to expect volatility to return: tariffs, deficits, inflation, social tensions and geopolitical shocks.”
Increased Defense Spending Will Raise Government Spending
In this scenario, which favors government bonds as a shelter from stock market volatility, investors, however, must weigh the risks of rising government debt in advanced economies. In Europe, according to Morningstar DBRS estimates, defense expenditures are projected to rise by EUR 800 billion by 2030 under the assumption that all countries decide to use a new budget escape clause in full.
“Achieving the target of allocating 5% of GDP to defense spending, while maintaining conservative fiscal deficit trajectories, will likely require European governments to make difficult budget trade-offs,” according to Mehdi Fadli, senior vice president in the Morningstar DBRS’ Global Sovereign Ratings Group.
“We consider that the three largest and most indebted countries in the EU- Italy, Spain, and France- were they to follow through on the new spending commitments without adjustments elsewhere, they could face significantly higher budget deficits over the medium term.”
However, Axa IM’s Iggo recalls how the recurring narrative of a European sovereign debt crisis never materialized.
“Not even at the most critical times, such as during the eurozone crisis of 2012, has there been a collapse, and yields on peripheral countries have indeed fallen,” he says.
What if the Fed Lowers Interest Rates?
Overall, managers have a positive outlook on eurozone government bonds, while they are cautious on US Treasuries, where the focus is on tax reform and debt sustainability in the medium to long term.
“Investors may demand a higher risk premium on long-term maturities to hold US government bonds, thus leading to higher yield levels,” says Generali Asset Management’s Spagnol.
“For these reasons, the market view remains cautious on US debt and moderately constructive on eurozone rates for the short and intermediate end of the curve.”
“It’s also likely that eurozone rates as a group may follow the path of US rates: If the Fed decides to lower rates in the US, Treasury yields, especially on the short-end, will likely come down, which could certainly push Eurozone rates in the same direction. The Fed is stuck between ensuring inflation is under control and their desire to support the economy amid uncertainty around tariffs,” Morningstar’s Pappalardo says.
Bunds or Peripheral Eurozone Government Bonds?
Finally, investors in eurozone government bonds must look to the ECB’s future moves. With declining inflation and weaker growth forecasts, the ECB has “room for an orderly descent of rates toward 1.50-1.75% by mid-2026,” says Daniele Bivona, manager of AcomeA SGR, who adds that the long and ultra-long end of the European core government curve “is back to offering value, with yields finally palatable after years of compression and price losses of around 50-60%.”
Bivona believes these bonds present “an excellent risk/return profile” particularly from a defensive perspective, while he is cautious on peripheral government bonds, given the tight spread levels against the German bund. For Generali Asset Management’s Spagnol, however, countries such as Italy, Spain and Greece contribute positively to portfolio profitability.
