"Iran Shock" Raises Concerns Over Fiscal Deterioration, Eurozone Borrowing Costs Surge to Multi-Year Highs

Ask AI · Will differences in how countries respond financially worsen divisions within the euro area?

Iran’s situation has pushed up energy prices, and inflation expectations have warmed accordingly. Eurozone government bonds have logged one of the worst monthly selloffs in nearly a decade. Borrowing costs in countries such as Italy, France, and Spain have been pushed to multi-year highs, and concerns in the market that governments may be forced to increase fiscal spending to protect consumers have intensified in parallel.

Italy’s 10-year government bond yield briefly rose to 4.14% this month, the highest since mid-2024. It has climbed by about 0.8 percentage points over the month, and the scale of the selloff is comparable to the previous round of the energy crisis in 2022. France’s 10-year yield touched nearly 3.9% intraday, the highest since 2009. Spain’s yield during the same period has been edging toward 3.7%, the first time since the end of 2023.

The Iran shock pushes up oil and gas prices and lifts inflation expectations; the European Central Bank may be forced to raise rates three times this year. At the same time, fiscal conditions in countries deteriorate due to energy subsidy measures, bond-market selloffs intensify, and borrowing costs spiral higher.

Inflation’s shadow returns, central banks take a cautious stance

According to the Financial Times, a member of the European Central Bank’s Executive Board, Isabel Schnabel, said bluntly in remarks on Friday that “the ghost of inflation has returned,” and that the pace of this shift is faster than “many” people expected. But she added that the European Central Bank does not need to “act in a hurry,” still has “time to observe the data,” and is waiting for further evidence of second-round inflation effects.

Bert Colijn, an economist at ING, said that part of the upward move in yields this time reflects investors closing positions that had bet on bond spread tightening, especially concentrated toward Italy. He said that so far there has been no clear sign of significant market concern about sovereign debt risk in the euro area, but that “if the situation continues to deteriorate and the costs of fiscal measures rise further, this risk may still surface.”

T Rowe Price’s chief European macro strategist Tomasz Wieladek said: “Investors are realizing that we are moving into a combination scenario of low growth and high inflation coexisting, together with additional fiscal stimulus and an expansion of government spending.”

Different countries respond with different intensity

In the face of the energy-price shock, eurozone countries’ fiscal responses differ in strength, but they generally face the same dilemma of limited room for maneuver.

On Thursday, Spain’s parliament approved a €5 billion tax-cut package that reduces value-added tax rates on electricity, natural gas, and fuels from 21% to 10%. The plan was proposed by left-wing Prime Minister Pedro Sánchez. Italy, meanwhile, is temporarily cutting fuel consumption tax by 20%. The measure runs until April 7, at a cost of about €417 million, when it will be assessed. Rome plans to make up for the tax revenue losses by cutting spending in other areas, including healthcare.

France chose to hold the fiscal line and did not roll out large-scale energy subsidies. Citing that the fiscal deficit-to-GDP ratio at the end of 2025 is as high as 5.1%, the prime minister said there is “no savings jar to draw on.” The government only introduced targeted measures for industries hit hardest, such as agriculture and truck transportation, costing about €70 million in April.

Simone Tagliapietra, a senior fellow at the Bruegel research institute, said that the measures announced so far by countries such as Spain have shown that “we are talking about large sums of money.” He warned: “European governments are constrained by their fiscal situation, with lots of competing demands—especially defense spending—and public budget room is very limited. I don’t think there is any fiscal space to deploy on the same large scale as in 2022 to 2023.”

Budget pressure increases, and the buffer space this time is narrower

The previous energy crisis provides a cautionary reference for the current situation. According to Bruegel think tank data, since the energy crisis erupted in September 2021, European countries (including the UK and Norway) together disbursed and set aside €651 billion to protect consumers from the shock of higher energy prices.

This week, the Organisation for Economic Co-operation and Development (OECD) said that many measures in the previous crisis were “not targeted enough” and that “fiscal costs were significant,” warning that the measures taken this time to buffer the rise in energy prices will “further aggravate the budget pressure most governments are facing today.”

Jean-François Robin, head of global research at Natixis CIB, said investors are betting that eurozone public finances “will worsen,” because countries are spending “a lot of public money” to absorb the shock.

Spreads reverse advantage, and threshold risk is emerging

This round of bond-market selloff has already reversed the spread advantage of heavily indebted members of the euro area versus Germany. Take Italy as an example: its 10-year government bond spread versus Germany’s was about 0.6 percentage points before the outbreak of the conflict, and has since risen back to close to 1 percentage point.

Several investors emphasized that, in historical terms, the current spread level is still moderate—Italy’s spread had at one point reached 3 percentage points during the pandemic. Pimco’s portfolio manager Konstantin Veit said that “the widening of spreads today does not invalidate the logic of long-term spread tightening,” and noted that only with several years of high interest rates combined with low growth would the market truly raise questions about debt sustainability.

However, some analysts have pointed to key threshold risks: if Germany’s 10-year government bond yield (currently around 3.1%) rises further above 3.5%, borrowing costs for Italy and France would be pushed toward the 5% area. Wieladek of T Rowe Price warned that at that time, “debt sustainability will become uncertain.”