Korea jitters reverberate in peripheral Europe, pushing bond spreads out

The premium investors demand to hold southern European bonds over top-rated German peers hit its highest in over three weeks on Friday as the risk aversion caused by heightened tensions over North Korea reverberated across peripheral Europe. While safe-haven German government bonds have benefited this week from the geopolitical tensions, the opposite has been true for the euro zone's lower-rated debt markets that often suffer at times of global uncertainty.
On Friday, US President Donald Trump said the US military was "locked and loaded" as North Korea accused him of driving the Korean Peninsula to the brink of nuclear war. Against this backdrop, the yield on Italy's 10-year government bond rose to its highest in just over a week at 2.05 percent, widening the gap over benchmark German Bund yields to around 166 basis points.
That gap marks the widest in over three weeks. It also reflects a 14 bps widening from 2017 lows hit earlier this week after data pointed to outsized buying of Italian debt by the European Central Bank for its asset purchase scheme.
"The only show in town this week has been the North Korea story," said Rabobank rates strategist Lyn Graham-Taylor. "There's been a classic risk-off trade." The Portuguese/German and the Spanish/German 10-year bond-yield spreads were also at their widest in around three weeks. Bond spreads across the periphery have tightened sharply in recent weeks, aided by so-called "carry trades" where investors borrow in low-yielding assets to invest in higher-yielding ones.
The damage inflicted on world stocks this week by the escalating war of words over North Korea meanwhile topped $1 trillion. In contrast, demand for safe-haven German Bunds continued to swell. Yields across the German curve were 2-3 basis points lower, briefly pulling away from their lows on news of a Russia, China plan to end the tensions.
Germany's 10-year bond yield - which moves inversely to the price - dropped below 0.40 percent for the first time since June 29. It fell 4 bps on the day to around 0.38 percent, more than 20 bps below its July peak. Short-dated two-year German bond yields were at their lowest level since mid-June at minus 0.71 percent.
This fall comes even though long-term euro zone inflation expectations have crept up and investors are anticipating a withdrawal of extraordinary monetary stimulus from the European Central Bank, factors that should normally push yields higher. Japanese, British and US 10-year government bond yields are also at their lowest level since late June.