EUR sovereign spreads: The carry sweet spot

Another, hopefully, lasting consequence of the Covid-19 pandemic was the joint EU fiscal response. The programme, dubbed NGeu (Next Generation EU), includes €350bn of cross border transfers over several years. If the annual disbursed amounts over the life of the programme are relatively modest compared to the size of the eurozone economy as a whole, its impact on smaller peripheral economies, Greece for instance, is nothing short of a game changer. Even for larger peripheral countries, the combination of supply reduction, fiscal stimulus, and monitoring is sending a positive signal to investors.

If NGeu helps address the reasons for intra-eurozone sovereign spreads, namely diverging growth and fiscal paths, it doesn’t solve them entirely. In that respect, the ECB is once again proving instrumental in suppressing peripheral borrowing costs and preventing further divergence. It is also the prospect of sustained central bank support that pushes private investors into chasing yields lower.

We see no major impediment to this dynamic continuing next year. On the contrary, still sizeable central bank support, some degree of fiscal solidarity between states, and too shallow a recovery to question either, will serve carry trades well. As more investors are drawn to peripheral debt, we expect the 10Y spread between Germany and Italy to narrow to 90bp by the end of 2021. This would be its tightest level since the onset of the sovereign debt crisis over a decade ago. To arrive at this forecast, we assume that Italian political risk will remain in check, with no general election before 2022, but most likely in 2023.

Safer sovereigns, France and Spain for instance, will fare comparatively less well. This is in part due to competition for investor demand stemming from EU debt issuance, and in part because of the economic damage wrought by the pandemic.