As Bond issuances took center stage as the new year started, periphery bonds continued to outperform the Bund. As time goes by, the outperformance of periphery bonds is probably here to stay as long as there are no significant risk-off events.

Since the beginning of 2023, peripheral countries have consistently outpaced core nations in economic growth. As a result, bond spreads over the Bund have narrowed significantly, with occasional attractive buying opportunities—such as during the French snap elections in June 2024. With equities continuing their upward trajectory and economic outperformance coupled with sound fiscal management, there’s little reason to expect spreads to widen. On the contrary, any potential widening would present a prime buying opportunity. US and German yields experienced a relief rally over the past week. After surging in December and the first half of January, yields on 10-year bonds dropped by 15 basis points in the US and 9 basis points in Germany, following a slightly lower-than-expected CPI in the US. With Trump now sworn in for a second term, the market remains uncertain about potential tariff threats. However, I would argue that he’s unlikely to impose the steep tariffs he promised during his campaign—particularly the 60% on China and the across-the-board 10% tariff. Any additional pressure on European manufacturers could be eased through lower interest rates and accommodative fiscal policies from Germany. Moreover, if tensions in Ukraine deescalate, it could further alleviate some of this pressure. Lower interest rates, combined with an expansionary fiscal stance under the new Chancellor (likely Merz), should help drive economic growth and, hopefully, reinforce Germany’s position as a manufacturing powerhouse. This would benefit Germany and other European countries heavily reliant on manufacturing and exports.

Over the past two years European periphery sovereign bonds performed superbly, and spreads to Bund have contracted significantly. Even though some countries did not have such good public finances as Croatia, most of them reduced their discount to the Bund, except France whose significant problems in the economy without political stability which may lead to significant deficits in the near future with very high debt burden even before any possible fiscal stimulus. As EURUSD keeps ranging between 1.05 and parity, that should also be great for peripheral economies as tourists from the US pay significantly less in the USD than ever before. A core question of this blog is the possibility of negative spreads of peripheral 10-year bonds to the Bund. In theory, that sounds impossible but exactly what happened in mid 2000’s. From the current perspective, if the current regime continues I would argue it might even happen in 2025 in Croatia or Slovenia as debt to GDP drops by a few percentage points every year and is on track to continue doing that. Similar to Portugal and Spain in 2006, Italy achieved 8 bps spread over Bund in 2006. Also, if Germany manages to loosen or remove debt break and deliver fiscal stimulus to finance structural investments in Germany, that should apply upward pressure on German yields, further supporting the negative spread thesis.

In conclusion, the outlook for periphery bonds remains strong as long as there are no significant risk-off events. The continued economic outperformance of peripheral countries, coupled with reasonable fiscal management, is likely to keep spreads tight and may even present buying opportunities in the future. The recent rally in US and German yields has provided some relief, but geopolitical and economic uncertainties remain. If Germany pursues expansionary fiscal policies, it could support economic growth and maintain its manufacturing strength, benefiting the broader European market. While some countries like France face challenges, the overall trend points towards a further reduction in spreads between periphery bonds and Bunds, potentially even leading to negative spreads for certain countries like Croatia or Slovenia in the following years. As the economic landscape evolves, periphery bonds could continue to outperform, offering attractive opportunities for investors, provided the favorable conditions persist.

10Y Bond yield vs Bund spreads

Source: Bloomberg, InterCapital