We talked yesterday about the U.S./Europe divergence created by the energy price shock.
The interest rate outlook in Europe has swung from prospects of a cut to 35 basis points of tightening by year end.
The euro is down almost 2.5% against the dollar since the war.
European stocks are feeling more pain than U.S. stocks.
This is the market beginning to price in the penalty of energy dependence, in a world where a key European LNG supplier (Qatar) has shut down production indefinitely.
Still, considering this Qatar reality, the market response has been mild. The expectations remain that the energy price pain will be short-lived.
If/when that expectation changes from short-term pain to longer-term damage, the first place it will show up is in Italian government bond yields.
This is where the budget sensitivity to energy prices is among the highest in Europe, and where the debt load is among the highest and most vulnerable to rising interest rates.
With that, Italian yields made the biggest move today since the start of the U.S./Iran war — the biggest move since November of 2024 (just after the U.S. election).
This chart below shows the key spread between Italian yields (Europe's weakest major bond market) and German yields (the anchor).
The red line is the 2022 period surrounding Russia's invasion of Ukraine — everything to the right of the black vertical line is the market reaction to the war catalyst.
The blue line is the current period. You can see the trajectory has been UP, which means more capital moving out of Italian government bonds (fiscally weaker, riskier).
But this chart also shows how low the absolute level of the spread is, relative to 2022 — which means a very low risk premium is priced into the European bond markets — yet with this major war and energy shock catalyst just arriving.
