Focus on Eurozone sovereign bond spreads, as it is an essential factor for valuing the Euro

As interest rates rise across countries, Eurozone sovereign bond spreads are back in the spotlight and of great interest to analysts, investors, traders and policymakers.

When bond spreads converge or diverge, the explanation relates to the divergence or convergence countries have with each other regarding their macroeconomic indicators. Indeed, indicators such as the high government debt of some countries reflect a macroeconomic environment of increasing countries' credit risk and liquidity risk, thereby increasing the spreads of government bonds against other countries.

However, in recent years it has been empirically proven that what plays the fundamental role in government bond spreads is what we call Markets. Therefore, to assess the direction and level of "spreads" between countries, it is necessary to create not only a macroeconomic model but also a model capable of focusing on market variables, which will be related to their effect on the interest rates of the bonds of that countries.

Spreads will be stable or even converge if countries are similarly affected by market variables. If, for example, one country is involved in the same way by commodity prices, energy prices or a market's regulatory framework to the same extent as another country, then the spread between government bonds will tend to converge.

However, if a country is affected differently by market variables due to, for example, some wrong decisions by the authorities of that country or due to an inefficient production structure of companies in that country relative to market conditions, then the increase in the spreads of bonds in this country will be inevitable.

As far as the Eurozone is concerned, the big issue is that a future increase in spreads between Eurozone countries will create turbulence, affecting the Euro.

The good news is that, as we can see in the charts below, despite the recent significant rise in eurozone government bond yields, the spread with the benchmark German bond has not changed significantly across eurozone countries since 2019, when the pandemic appeared. It seems that the markets at this stage affect each of the eurozone countries, in the long term, that is, the long-term government bonds in the eurozone countries, to a roughly constant degree, since the difference with the benchmark remains relatively stable as in the previous three years.

Investors, traders and policymakers must focus on whether these conditions will persist. That is, to be able to assess whether, in the future, there is a tendency to increase, decrease or stabilize the existing spreads in the countries of the Eurozone. In this regard, as already mentioned, they do not need to focus only on macroeconomic indicators but mainly on market indicators. Market indicators will indicate the increase or decrease of spreads and, therefore, the increase or decrease of risks in the European currency.

Implementing decisions such as the common rules and regulations for the management of market conditions taken or to be taken by the euro area countries is a market indicator of great importance to keep spreads at tolerable levels and, therefore, not to increase the risk for the euro currency. Whether this is achieved in the future will determine how investors, traders and policymakers should react.