Euro zone government bond yields remained close to their highest levels in more than 15 years on Monday as the prospect of a prolonged conflict in the Middle East heightened concerns that energy-driven inflation could prove more persistent. According to Reuters, Germany's benchmark 10-year Bund yield was up one basis point to 3.21% after reaching 3.2158%, the highest since May 2011. The two-year German yield, which is more sensitive to expectations for monetary policy, was also broadly unchanged at 2.79%. The bond market has increasingly reflected expectations that the European Central Bank may need to raise interest rates if higher energy prices keep inflation elevated, with money markets pricing in an ECB deposit rate of around 2.76% by March 2027, compared with the current 2.25%, while implying a more than 90% probability of a rate hike in September. As per The Economic Times, investors fear not only higher inflation but also a rise in defence spending if geopolitical tensions persist, increasing debt issuance and adding to pressure on bond markets.
French government bonds experienced significant pressure as investors fear France's fiscal trajectory is unlikely to improve ahead of a presidential election scheduled for spring 2027. France's 10-year government bond yields were up 1.5 basis points at 4.05%, after hitting 4.0581%, the highest level since June 2009. According to The Economic Times, yields on 30-year government bonds reached 4.8617%, the highest since September 2008, up 2 basis points on the day. The yield gap between 10-year OATs and Bunds was at 84 basis points, not far from its highest level since October 2025. Some analysts argued that, in a low-volatility environment, investors' search for yield could help limit any widening in the spread between French government bonds and safe-haven German Bunds. The fiscal concerns add another layer of pressure to euro zone bond markets beyond the immediate inflationary concerns.
The latest market pricing marks a significant shift from expectations earlier in the year, when investors largely anticipated a stable or easier monetary policy path. As per Reuters, Jefferies economist Mohit Kumar expects the ECB to deliver no more than one rate increase, arguing that current oil prices remain below the adverse scenarios considered by the central bank in June. The view suggests that while energy prices pose an upside risk to inflation, they may not yet warrant a prolonged cycle of monetary tightening. Iran urged the United States to accept defeat on Saturday, while U.S. President Donald Trump warned Americans to prepare for continued high fuel prices as a consequence of the war, adding to geopolitical uncertainty that is driving market caution about the inflation outlook. Market participants have noted that U.S. President Donald Trump has signalled a strategy that relies more on economic pressure through a naval blockade of Iran than on direct military action, describing the current situation as a stalemate.
The divergence between euro zone sovereign bonds was also evident in Italy, with the yield premium on 10-year Italian government bonds over German Bunds standing at around 77 basis points on Monday. According to Reuters, that spread was significantly narrower at 63 basis points in February, before the attack on Iran, but widened to 103.62 basis points in late March, its highest level since June 2025. The widening spread highlights the renewed sensitivity of peripheral euro zone debt to geopolitical and inflation risks, with higher borrowing costs potentially complicating fiscal policy across heavily indebted economies if elevated yields persist. As per The Economic Times, Italy's 10-year government bond yield rose 1.5 basis points to 4.0%, while its 30-year counterpart hit 4.8254%, the highest since November 2023. The yield gap with Bunds was at 77 basis points, showing the continued pressure on Italian debt.
The euro added mild gains from a one and half week low against the dollar on Friday morning after Germany's latest inflation data showed wholesale prices rose 5.3% year-on-year in July, accelerating from a 4.9% increase in the previous month. According to Business Standard, this marked the slowest growth in three months, with wholesale prices edging up 0.2% on a monthly basis, reversing a 0.7% decline in June and marking the first increase in three months, although the rise was below the 0.4% expected. The EUR/USD pair is currently quoting at $1.1555, up 0.10% on the day and edging higher from a one and half week low, with the weakness in the US dollar following softer than expected US inflation data also supporting the euro's gains. Oil prices, the main inflation driver, rose on a lack of progress in diplomatic efforts to resolve the Iran war, though the absence of major supply outages limited gains.
On the domestic front, EUR/INR futures are down 0.10% at 128.91 on the NSE, as per Business Standard, with the euro's recovery against the dollar providing some relief for Indian markets. India's July inflation data, due later Wednesday, is expected to show inflation rising to 4.50% from 4.38% in June, while a hotter-than-expected US reading could revive Fed rate-hike bets and put upward pressure on Indian yields by narrowing the yield premium over US bonds. However, India's July CPI rose to 4.45% from 4.38% in June, below the 4.50% forecast and comfortably within the RBI's tolerance range. Despite the near-term pressure from oil and US yields, sentiment toward Indian bonds remained relatively supportive after the RBI kept its repo rate unchanged and lowered its inflation forecasts at last week's policy meeting, leading analysts to push back expectations for future rate hikes. Strong foreign inflows and ample liquidity have also supported bonds, with the RBI's diaspora deposit scheme attracting over $36.7 billion as of July 17, while the daily average cash surplus exceeded INR 3 trillion in August.
