Rates Spark: Spread exposures

Geopolitics continue to drive volatility and as conflicting signals dampen hopes for a quick solution to the conflict, oil prices have drifted higher, closer to the US$100/bbl threshold again.

The resulting market volatility and more aggressive central bank pricing also feeds into bond spreads. In eurozone government bond spreads, Italian spreads have suffered the most. The 10y spread over German Bunds had peaked towards 95bp by the end of March before easing lower to now stand at just above 70bp, still more than 10bp above levels observed just before the turmoil. Less impacted have been French spreads, but they also sit around 6bp wider compared to before the crisis.

If we model the countries’ 10y OIS spreads since the end of January by just taking oil prices as input, we can already explain 83% of the Italian spread dynamic. Oil alone also explains close to 70% of French spread dynamics, but only about 23% of Spain’s. That, of course, is reflective of how much these economies are exposed to higher energy prices. Italy is reliant on gas imports, especially from the conflict region, while France is regarded as shielded to some extent by its higher nuclear energy share.

We also see consensus 2026 GDP forecasts for Italy having been revised lower by around 0.3% to now 0.5% since the start of the crisis. We see a revision of similar magnitude for France, though, by 0.3% to 0.7%, whereas Spain has seen only a marginal downward revision to still stand at around expected 2.2% growth for this year. Deficit revisions since the crisis hit have been smaller, also given that fiscal responses overall have been quite limited in scale so far, with overall debt levels already strained in many cases.

Our view is that downward potential for oil prices, even in a more benign outcome, remains limited in the near term, with average prices still around US$90/bbl by the end of the year. Alongside some normalisation in central bank pricing, that would give Italian spreads some 7bp of tightening potential and France a bit more than 2bp. It wouldn’t change the picture for Spain in the simple model. Here we would expect any tightening to come via the lower market volatilities and improving risk sentiment in general.

However, oil and central bank pricing have for now shared a very similar dynamic, linked by inflation. If the crisis drags on, dynamics could still drift apart when the ECB increasingly contemplates second-round effects, even without energy prices necessarily rising much further. That could leave the likes of Italy still more exposed, not just in an escalation scenario.

From the eurozone we’ll get retail sales numbers from April, for which consensus sees the growth decelerating from 1.2% to 0.3% year-on-year. More interesting could be the US Challenger jobs numbers and jobless claims. Any signs of weakness in the jobs markets could have markets preposition for the all-important US non-farm payrolls number on Friday. The European Central Bank’s quiet period will also start in anticipation of next week’s (11 June) monetary policy meeting.

For supply, Spain will auction 3y, 5y, 15y SPGBs, and a 14y SPGBei for a total of €6.25bn. France will auction new 10y, 12y, 16y and 31y OATs for a total of €14bn.