The financial environment in the euro area has undergo dramatic shifts, especially in the area of sovereign bond spreads. Italian government bonds have been in the news of late. Its 10-year spread over German Bunds recently fell below 100 basis points, hitting an all-time low spread of 90 basis points earlier this month. This trend was almost lost in the noise of a massive re-widening of spreads on other eurozone government bonds. Domestic political developments in key markets such as France are well behind this pivot.
While the entire market processes the implications of these changes, Dutch pension funds are proactively preparing and positioning themselves. The two other major pension funds in the Netherlands, ABP and PFZW, manage a combined asset value of roughly €800 billion. They are quickly adding interest rate hedges to get ready for major balance sheet reforms scheduled to take effect in 2026 and 2027.
Shifts in Italian Government Bonds
This is especially remarkable, given the current financial climate around Italian government bonds. The 10-year spread over Bunds fell below 100 basis points last month, a key marker of market confidence. In the first week of this month, we were recording a spread as low as 90 basis points. This indicates that investor sentiment toward Italian securities has improved in the immediate term.
Yet even as this is a positive development for Italy, the broader eurozone dynamics tell a much worse tale. Spreads in the few remaining core eurozone countries have started to widen again. This rewidening is said to result from multiple domestic pressures in member states, though France’s recent troubles have arguably been the most powerful. What is happening in France has alarmed markets and eurozone policymakers deeply. This unrest is affecting how investors view the market and is affecting behaviors in the bond market.
The Role of Dutch Pension Funds
Given the adverse movement in global markets, Dutch pension funds are acting decisively. ABP and PFZW, the two largest pension funds in the Netherlands, are focusing on interest rate hedges as they prepare for future reforms. Almost all of these funds have poor interest coverage ratios. This demonstrates the clear need for effective hedging strategies to keep funding ratios stable when market conditions change.
The market anticipates at least one more rate cut from the European Central Bank (ECB). Consequently these pension funds are greatly accelerating their hedging, which will carry through on into the first quarter of 2025. By securing their positions against interest rate risks, they aim to enhance their financial resilience and ensure stability in their funding ratios as they transition towards new reforms.
Inflation Swaps on the Rise
The other important trend in the financial markets is the growth of short-dated inflation swaps. The 2-year EUR inflation swap has jumped by a big step from 1.5% to above 1.8% in June. This increase is a reflection of increasing market expectations regarding the trends of inflation. It further illustrates the difficulty for investors to plan amid turbulent economic conditions.
The jumps in inflation swaps are tied deeper into the national political and economic landscape, with stark domestic crises overtaking eurozone members. Our inflation expectations are all shifting. Investors are keenly awaiting the impact of these transitions on the ECB’s monetary policy trajectory and eurozone economies’ stability.