Three threats to the euro: how the fuel crisis could bankrupt Europe
Against the background of rising oil and gas prices around the world, the problem may worsen in Europe, which has temporarily receded into the background. In recent years, the largest European countries have faced an increase in national debt yields with a parallel increase in borrowing. The looming fuel crisis may complicate the situation radically. This applies to both EU states and the UK. Details can be found in the Izvestia article.
The worst month of the year
British government bonds (gilts) are completing their worst month since the historic collapse that cost former Prime Minister Liz Truss her seat. The index, which tracks the dynamics of the classic gilt portfolio, sank by almost 5% over the current month. This is the deepest drop since the eight percent decline in September 2022. The massive sell-off wiped 108 billion pounds from the benchmark's market capitalization, dropping it to 1.63 trillion pounds by the close of trading on Friday.
At the same time, the yield on benchmark 10-year German government bonds (bunds), the main barometer of borrowing costs in Europe, soared from a comfortable 2.1% to 3.4% per annum in just three weeks. For the German Finance Ministry, this means an increase in the cost of servicing new debts at a time when the German economy is already teetering on the brink of recession due to US duties and rising energy prices.
In the south and west of the continent, the picture is perhaps even more dramatic. The yield of 10-year French securities broke through the psychological mark of 4.2%. The French budget, which has been running a chronic deficit for years (consistently above 5% of GDP), is now facing a rapid increase in public debt servicing costs. The spread (yield difference) between French and German securities has widened to 90 basis points, levels not seen since the eurozone crisis of the early 2010s.
Italy, traditionally the weakest link in the European financial system, has reached a rather dangerous line. The yield on 10-year securities crossed the 5.3% barrier. The spread with German bonds exceeded 200 basis points, triggering alarm in the offices of the European Central Bank (ECB). With public debt exceeding 140% of GDP, refinancing liabilities at 5% per annum makes the Italian fiscal model untenable in the long term.
The sharp rise in yields is a consequence of the breakdown of market expectations. Back in January, investors had been pricing in at least three ECB base rate cuts in 2026. The market was counting on Christine Lagarde (ECB President) to start saving European industry with cheap money.
The war in the Middle East has thwarted these plans. Oil above $100 per barrel and rising spot gas prices guarantee a surge in imported inflation. The ECB is trapped in a stagflationary trap. The regulator cannot lower rates — this will bring down the euro exchange rate by purchasing energy resources (which are traded in dollars) even more expensive, and it will finally derail inflationary expectations. Investors, on the contrary, are starting to put new rate increases in prices.
The tightening of monetary policy in the current conditions means additional suffering for the European economy and industry, which is already in a multi-year recession due to a shortage of affordable raw materials. The ECB is forced to choose: to save the purchasing power of the euro or national budgets from defaults.
The main threats
If the military conflict drags on for several more months, the European debt market may face three fundamental threats that can trigger a crisis throughout the system.
The first threat is a fiscal explosion. Expensive energy requires a political response from governments. In order to prevent mass bankruptcies and social uprisings, the authorities of France, Italy and Spain will be forced to introduce large-scale energy subsidies for the population and businesses. These programs can only be financed through new loans. Entering the market with huge amounts of new debt at a time when investors are already fleeing from European assets will lead to further uncontrolled growth in yields. A classic spiral will arise: new debts are taken on at an increasingly high interest rate in order to pay off the interest on the old ones.
The second threat is the return of the "death loop" between banks and states. The European financial system is designed so that local banks are the largest holders of government bonds of their countries. Italian banks are filled to the brim with the papers of the Italian Ministry of Finance, French banks are filled with the papers of the French Ministry of Finance. When the value of these bonds plummets (and yields rise accordingly), holes form in the banks' capital. Financial institutions will be forced to drastically reduce lending to the real sector in order to save their own balance sheets. This will provoke a full-scale paralysis of the entire EU economy.
The third threat is the political split within the ECB. To save the debt market of Italy and other southern countries, the ECB has a special tool (TPI — Transmission Protection Instrument) that allows the regulator to buy bonds of troubled countries to bring down yields. In practice, launching this mechanism means that the entire eurozone takes over financing the Italian or French deficit.
In peacetime, Berlin could turn a blind eye to this. But now the German economy itself is in a difficult state caused by the loss of cheap gas and American duties. German taxpayers, the Bundesbank and the courts may categorically oppose the idea of printing euros to save their southern neighbors when their own factories in Bavaria and the Ruhr are closed due to unprofitability. The conflict over financial burden sharing risks escalating into a political crisis.
The need for autonomy
In general, the European public debt market is paying the price for the continent's lack of strategic autonomy. The United States, which initiated a forceful solution to the Iranian problem, has a powerful domestic capital market, its own energy base and the status of the dollar as a reserve currency. Capital fleeing from Middle East risks is parked in US Treasury bonds, strengthening the dollar and softening the blow for Washington.
Europe is deprived of these privileges. The continent is importing inflation, losing its energy base, and facing an outflow of investment capital. If the war continues for several more months, it will no longer be about recovery from the crises of 2020 and 2022, but about the physical survival of the financial sector and the economy of the continent's leading states.
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