By Alun John, Harry Robertson and Sara Rossi
LONDON/MILAN, Oct 7 (Reuters) - Traders have turned more discerning following a bond market rout, dumping the debt of European countries they deem the riskiest and rushing to safe-haven Germany.
The moves highlight a new hierarchy in the ever-evolving rankings of European debt.
France, once a beneficiary of a flight to safety, has been hit by selling. Previously shunned Italy and Britain are less exposed but still fragile, while Dutch and Swiss debt have
rallied alongside Germany.
"We've seen bond vigilantes come out in force," said Man Group Chief Market Strategist Kristina Hooper.
"They are punishing those countries that they do not believe are fiscally disciplined. We can see that in yields across Europe in the past week."
FRANCE WOBBLES
France is at the centre of a storm on worries about the country’s large budget deficit and looming 2027 presidential election.
Its 10-year bond yield jumped 70 basis points (bps) in September and hit its highest since 2002. That is driving up borrowing costs and making the fiscal maths harder.
France said in September that the deficit will overshoot the government’s 5% target. The government has announced belt-tightening measures to bring some calm, but investors are sceptical that they can be carried out. Meanwhile, France plans to sell a record €340 billion ($381 billion) of bonds in 2027 to fund the government and refinance COVID-era debt.
The spread between French and German 10-year bond yields, a gauge of France's risk premium, hit almost 160 bps last week, its highest since 2012. While the spread retreated somewhat earlier this week, it is widening again on Wednesday, in a move which many investors expect to continue.
The euro, hurt by the selloff, could weaken to $1.10, analysts say.
Still, the yield gap between Germany and other euro zone countries is far below peaks seen in the European debt crisis, when Italy's spread topped 500 bps and Greece's 3,000 bps.
ITALY UNDER PRESSURE
Investors worried about the sustainability of Italy's public finances fear contagion from the France selloff.
Italy's 10-year bond yield gap over Germany widened to 130 bps last week from 80 bps a month earlier.
Its bond market could come under more pressure should debt-related worries resurface.
Italy's cabinet said last week its deficit is set to rise well above the European Union's 3% ceiling and the country's massive public debt will start to fall only in 2028. Its debt-to-GDP ratio, currently at 138.6%, is expected to overtake Greece's this year as the highest in the bloc.
TS Lombard European and global macro director Davide Oneglia said he was also watching politics in Italy, which holds an election next year and could face uncertainty.
The Greek/German bond-yield spread, meanwhile, has hit its highest level in two years, while the Belgian 10-year yield rose 49 bps in September, more than most peers bar France.
BRITAIN, SPAIN DODGE WORST
Previously pressured bond markets in Britain and Spain have dodged the worst of the recent drama.
The turmoil in Britain's gilt market in 2022 around then Prime Minister Liz Truss' "mini-budget" has become a case study of how high debt levels can spook bond investors. Gilts underperformed in subsequent global selloffs.
But the 10-year gilt yield rose 36 bps in September to around 5.43%. That was around half the move in France.
Investors are less nervous about an October UK budget, but will be looking for reassurance on fiscal discipline as well as plans to boost long-term economic growth.
Spanish debt was once among the least favoured in the euro zone, but strong economic growth in recent years has driven a rally in its bonds. Its 10-year yield is now 75 bps below France's; it was 500 bps above during the 2012 euro zone crisis.
Investors say Spain is a test of how much worries about France infect other markets.
"Full-on contagion would involve ... a more pronounced widening in other European sovereign spreads, including those of countries with stronger fundamentals, such as Spain and Portugal," said Jeff Mueller, co-head of fixed income at Morgan Stanley Investment Management.
INVESTOR DARLINGS
Germany is back as Europe's safe haven. Recent fears it might lose that status due to higher spending on infrastructure and defence have proved overdone for now.
The German 10-year Bund yield fell 17 bps last week, even as France's jumped 13, as investors sought safety.
Japan's Sumitomo Mitsui DS Asset Management, for example, said on Tuesday it recently sold some French bonds in favour of German and Japanese debt, describing the decision to buy German bonds as a "flight-to-quality move".
The debt of other low-debt European countries also rallied last week. Dutch yields fell 11 bps, the Swiss, 12, and the Swedish, 14.
($1 = 0.8929 euros)
(Reporting by Alun John, Harry Robertson and Sara Rossi; editing by Dhara Ranasinghe and Xevi Fontdegloria)
