Tensions surrounding Iran have driven up energy prices, fueling inflation expectations and triggering one of the most severe monthly bond sell-offs in the eurozone in nearly a decade. Borrowing costs for Italy, France, and Spain have surged to multi-year highs, intensifying market concerns that governments will be forced to increase fiscal spending to shield consumers. Italy's 10-year government bond yield climbed to 4.14% this month, its highest level since mid-2024, with a monthly increase of approximately 0.8 percentage points, matching the scale of selling seen during the 2022 energy crisis. France's 10-year yield touched nearly 3.9%, the highest since 2009, while Spain's equivalent yield approached 3.7%, a level not seen since the end of 2023.
Rising oil and gas prices due to the Iran shock have heightened inflation expectations, potentially forcing the European Central Bank to implement three interest rate hikes this year. At the same time, national fiscal positions are deteriorating due to energy subsidy measures, exacerbating bond market sell-offs and creating a spiral of increasing borrowing costs.
Inflation concerns have resurfaced, prompting a cautious stance from central bankers. European Central Bank Executive Board member Isabel Schnabel stated on Friday that "the specter of inflation has returned," and the speed of this shift has exceeded "many people's" expectations. However, she noted that the ECB need not "rush to act" and still has "time to watch the data" while awaiting further evidence of secondary inflation effects.
ING economist Bert Colijn suggested that part of the yield increase reflects investors unwinding previous bets on narrowing yield spreads, particularly focused on Italy. He noted that significant market concern over eurozone sovereign debt risk has not yet been observed, but warned that "if the situation continues to deteriorate and fiscal measures become more costly, this risk could still emerge." Tomasz Wieladek, Chief European Macro Strategist at T Rowe Price, added, "Investors are realizing that we are entering a scenario combining low growth and high inflation, alongside more fiscal stimulus and expanded government spending."
Eurozone countries are responding to the energy price shock with varying degrees of fiscal measures, but all face limited room for maneuver. Spain's parliament approved a €5 billion tax cut package on Thursday, reducing the value-added tax rate on electricity, natural gas, and fuel from 21% to 10%. The measure was proposed by leftist Prime Minister Pedro Sánchez. Italy has temporarily cut fuel excise taxes by 20%, a measure lasting until April 7 at an estimated cost of €417 million, after which it will be reassessed. The Italian government plans to offset the revenue loss by cutting spending in other areas, including healthcare.
France has chosen to maintain fiscal discipline, refraining from large-scale energy subsidies. The French Prime Minister cited a projected fiscal deficit of 5.1% of GDP by the end of 2025, stating there is "no piggy bank to dip into." The government has only introduced targeted measures for heavily affected sectors such as agriculture and trucking, costing approximately €70 million in April.
Simone Tagliapietra, a senior fellow at Bruegel, noted that measures announced by countries like Spain demonstrate that "we are talking about large sums of money." He warned, "European governments face fiscal constraints and numerous competing demands, especially for defense spending. Public budget space is very limited. I do not believe there is fiscal space for large-scale intervention like in 2022–2023."
The current situation draws cautionary parallels to the previous energy crisis. According to Bruegel data, since the energy crisis began in September 2021, European countries (including the UK and Norway) have allocated or earmarked a total of €651 billion to protect consumers from rising energy prices. The OECD noted this week that many response measures in the last crisis were "not well-targeted and came at significant fiscal cost," warning that current measures to cushion energy price increases will "further exacerbate budget pressures already faced by most governments."
Jean-François Robin, Global Head of Research at Natixis CIB, stated that investors are betting that eurozone public finances "will deteriorate" as countries spend "large amounts of public money" to absorb the shock.
The ongoing bond sell-off has reversed the yield spread advantage of highly indebted eurozone members relative to Germany. For example, Italy's 10-year bond spread over German bunds was around 0.6 percentage points before the conflict but has since widened to nearly 1 percentage point. Several investors emphasized that current spread levels remain moderate by historical standards—Italy's spread reached 3 percentage points during the pandemic. Konstantin Veit, Portfolio Manager at bond giant Pimco, said, "The current spread widening does not negate the long-term logic of spread narrowing," noting that it would take years of high interest rates and low growth to raise genuine debt sustainability concerns.
However, some analysts highlight a key threshold risk: if Germany's 10-year bond yield (currently around 3.1%) rises further above 3.5%, borrowing costs for Italy and France could approach 5%. T Rowe Price's Wieladek warned that at that point, "debt sustainability would become uncertain."
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