The fear gauge in Europe has reached its highest level since May 2020

Italian borrowing costs are rising at a time when consumers are increasingly concerned about the cost of living crisis.

Stefano Guidi | Getty Images News | Getty Images

A measure known as the Fear Barometer in Europe has reached its highest levels since the outbreak of the Corona virus, in what could lead to more economic pain for Italy in particular.

The difference in Italian and German bond yields is seen as a gauge of stress in European markets and investors are watching closely. The spread widened on Monday to levels not seen since May 2020, indicating – among other things – that markets are becoming increasingly concerned about Italy’s solvency.

The Italian 10-year bond yield rose to 4% – a level not seen since 2014.

The picture is similar in other debt-burdened countries in Europe.

The Greek 10-year bond yield reached 4.43% on Monday, while the 10-year yield in Portugal and Spain rose to 2.9%.

“Returns everywhere are rising due to inflation concerns, and growing expectations that central banks will have to raise rates aggressively in response,” Neil Schering, chief economist at Capital Economics, told CNBC.

“The biggest concern in the Eurozone is that the European Central Bank has so far failed to detail how a program to contain peripheral bond spreads will work. This is causing unease in the bond market, resulting in higher marginal price spreads.”

The European Central Bank last week confirmed its intention to raise interest rates in July, and its revised economic forecasts indicated that it is on the cusp of embarking on a tighter monetary policy path.

However, central bank officials failed to provide any details about possible measures to support heavily indebted countries, which is worrying some investors.

This lack of support may be more of a problem for Italy than for other southern European countries.

“Greece and Portugal should be able to handle more normal returns. Their growth trend is high, financial position [is] relaxing. As for Greece, most of the debt is owned by official creditors who have given Greece very favorable terms. Markets may worry about it, but fundamentals do not justify such concerns,” Holger Schmieding, chief economist at Berenberg, told CNBC.

“The real question remains Italy. Despite some reforms under [Prime Minister Mario] Draghi, the growth of the Italian trend is still weak. For Italy, returns of more than 4% may turn out to be a problem in the end.”

The International Monetary Fund said in May that it expects Italy’s growth rate to slow this year and next. Annual growth is expected to be around 2.5% this year and 1.75% in 2023.

The Fund also warned that “further sudden tightening of financial conditions could reduce growth further, increase the cost of financing and slow the decline in public debt, and cause banks to reduce lending.”

The return of austerity?

High borrowing costs in southern Europe are not new.

At the height of the sovereign debt crisis, which began in 2011, bond yields soared and a number of countries were forced to impose painful austerity measures after asking for a bailout.

However, despite the recent rise in yields and expectations of higher inflation in the coming months, economists do not believe we are on the verge of seeing a return to austerity in the region.

“Austerity as a policy response is still not likely. Italy and other countries are receiving big money from the EU’s Next Generation Program of 750 billion euros anyway. Public investment is likely to rise,” Schmieding said.

The EU’s Next Generation programme, which sees EU countries jointly borrowing money from markets, was introduced in the wake of the pandemic.

“Right now, the economic outlook is very uncertain and markets are at a loss for this record high inflation,” said Francesco Di Maria, fixed income analyst at UniCredit.

“However, unlike in 2011-2012, when the sovereign debt crisis occurred, the infrastructure of the European Union improved,” he said, adding that the European Central Bank was also likely to intervene if bond yields rose significantly.

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