Deutsche Bank highlights risk from bond-equity pricing divergence

A risk-off move that closes the gap between bonds and equities -- rather than an easing of stress -- would give the US dollar an extra boost, according to Deutsche Bank, leaving the euro and high-beta currencies more vulnerable. The euro is facing two headwinds: widening spreads on French and Italian debt signal fragmentation risk within the currency union. Oil is contributing to the inflationary pressure driving yields higher, and the bank's observation that futures are still priced for a normalisation next year implies energy risk may be undervalued across the curve. For equity holders, prices near records offer little buffer if credit spreads start to reflect the stress seen in sovereign bonds.

The sharpest sovereign shock in decades hit Europe's bond market last week, yet equities showed little response. According to Deutsche Bank, that calm is unlikely to last if the stress does not subside quickly.

Key takeaways:

• Bond and equity markets are pricing very different macro scenarios, according to Deutsche Bank.
• Last week's 32-basis-point widening of the French-German 10-year yield spread was the largest weekly move in Bloomberg data going back to 1990, leaving the spread at its highest since 2012.
• The Italian spread over Bunds increased by 23 basis points over the same period.
• The STOXX 600 dropped just over 1% and remains within 4% of its all-time high, while euro investment-grade credit spreads hover around 100 basis points.
• Bond markets are signalling high yields, faster rate hikes, and oil above $100, but the VIX is low and oil futures continue to price a return to normal next year.
• Deutsche Bank says either stress fades quickly -- as it did after Silicon Valley Bank's collapse in 2023 -- or equities and credit will need to reprice for slower growth and greater default risk.

Following last week's sharp European sovereign stress, which provoked only a muted reaction from stocks and corporate debt, Deutsche Bank warned that bond and equity markets are pricing two very different scenarios. The bank argues this gap is unlikely to last, and that either financial stress eases quickly or risk assets will have to adjust to weaker growth and higher default risk.

The French-German 10-year yield gap widened by 32 basis points last week, according to Deutsche Bank macro strategist Henry Allen. That was the biggest weekly jump in Bloomberg records going back to German reunification in 1990, and it pushed the spread to its widest since 2012. Over the same period, the Italian spread over 10-year Bunds increased by 23 basis points.

According to Allen, the recent moves are similar to past crisis periods when sovereign stress coincided with large losses in risk assets. In the euro-area debt crisis of 2011–2012, the pandemic shock of March 2020, and the 2022 selloff, government bond contagion was accompanied by major declines in European equities.

This time, the response has been much more subdued. The STOXX 600 fell just over 1% last week and is still within 4% of its record peak, while euro investment-grade credit spreads closed the week at roughly 100 basis points — far below the levels seen in those earlier episodes. Allen called the mix of sharply wider sovereign spreads with minimal equity losses and only small credit widening highly unusual, noting that rates markets were pricing in contagion and a significant growth hit that other asset classes had not yet accounted for.

A wider Deutsche Bank analysis places the same divergence in a global context. The bank sees bond markets already signaling a new macro regime with multi-decade-high yields, faster rate hikes, and oil above $100 a barrel, while equities stay near record highs, the VIX remains low, and credit spreads show little stress. Oil futures, the bank notes, are still pricing a return to normal next year, even though that call has been wrong repeatedly.

Deutsche Bank concludes that bonds have incorporated the warning but risk assets have not priced in the consequences. The bank cites the aftermath of Silicon Valley Bank's fall in March 2023 as a model for a benign scenario where stress quickly subsided. In the absence of a similarly rapid easing of conditions, the bank expects mounting pressure on equities and credit.