Euro zone bond yields rise as debt sustainability worries resurface

Euro zone government bond yields rose on Wednesday, taking their cues from Britain's gilts where yields spiked higher after the government scaled back plans to cut benefits, reigniting worries about global fiscal sustainability. British bonds suffered a steep sell-off as concerns for the nation's finances resurfaced following the government's U-turn on welfare cuts.

UK Prime Minister Keir Starmer's office rushed to give Finance Minister Rachel Reeves his full backing as analysts speculated she could lose her job after she appeared visibly upset in parliament. Reeves has repeatedly emphasised her commitment to self-imposed fiscal rules, limiting the amount Britain will borrow to try to build the confidence of investors.

Euro zone yields rose in tandem, especially those of the more indebted southern European countries. "Recent market reaction reflects the market concerns on the credibility of the government to bring down fiscal deficits," said Jefferies economist Mohit Kumar.

"We have a spillover effect from gilts onto European govvies (government bonds) particularly on countries with weaker fiscal dynamics," Kumar added. Germany's 10-year yield, the euro zone's benchmark, was up 5 basis points at 2.616%, rising to its highest since May 23.

10-year yields in France, Italy and Spain, which have higher debt-to-GDP than Germany, rose between 6 and 7 bps. Britain's 10-year yield was last up 14.5 bps at 4.602%, having earlier risen as high as 4.681%, its highest since June 9.

Investors in bonds around the world are growing increasingly nervous about government deficits from Japan to the United States, though Britain is seen as among the more vulnerable. Germany recently approved its draft budget for 2025 and a budget framework for 2026 which included increased borrowing and record investment to revive the economy.

Germany's two-year yield, which tends to be the most sensitive to changes in interest rate expectations, was up 1.5 basis points on Wednesday at 1.86%. Investors fully expect the European Central Bank to pause its interest rate cutting cycle when it meets later this month, as inflation returned to the 2% target in June, data showed on Tuesday.

Two ECB policymakers warned on Tuesday about the hit from a further appreciation of the euro on a weak euro zone economy that is bracing for higher U.S. import tariffs. Money markets show traders are pricing about a 90% chance of one more quarter-point rate cut this year from the ECB, which would bring the benchmark deposit rate to 1.75%, from 2% now.

"ECB officials agree that after cutting interest rates by 200 basis points, 2% inflation and 2% interest rates could be a sustainable sweet spot to go through trade policy uncertainty and geopolitical risks," said SGH Macro president Sassan Ghahraman. The 90-day pause that Trump activated following the market chaos unleashed by his April 2 "Liberation Day" tariff announcement expires in a week.

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