Yen Slides Again As Election Bets Build

The gap in borrowing costs between Southern European governments and Germany has shrunk to its narrowest point since the 2008 Lehman Brothers collapse. This rally, driven by expectations of European Central Bank interest rate cuts, has compressed yield spreads to levels not seen in over a decade.

However, investors and analysts are questioning how much further this trend can run. Without deeper institutional reforms and with new geopolitical pressures forcing a rethink on spending, the era of easy gains may be coming to an end.

The Great Compression: Why Spreads Are Shrinking

Since late 2023, the yield premium that countries like Italy, Spain, and Portugal pay over ultra-safe German Bunds has steadily declined. The catalyst was the growing certainty that the ECB was preparing to lower interest rates.

This has brought spreads to historically tight levels:

• Italy: around 53 basis points (bps)

• Spain: around 37 bps

• Portugal: around 24 bps

• Greece: around 43 bps

While impressive, these levels are still wider than in 2007, before the global financial crisis when debt loads were much smaller. Back then, Italy's spread was about 22 bps, while Spain and Portugal were near 5 bps.

Figure 1: Yield spreads for Italy, Spain, and Portugal over German Bunds have compressed dramatically since the 2011-2012 sovereign debt crisis, recently hitting their lowest points since before 2008.

Roadblocks to a Unified Bond Market

Market participants believe there's limited room for spreads to fall further toward a unified point. Such a convergence would be a critical step in creating a deeper, more liquid European bond market and strengthening the euro's global role.

Konstantin Veit, a portfolio manager at PIMCO, notes that the pre-crisis optimism was fueled by a different dynamic. "It wasn't always about fundamentals," he said, explaining that spreads were near zero "because there was a hope that over time, the monetary union would evolve into a fully-fledged fiscal and political union."

That hope remains unfulfilled. "We remain constructive on peripheral spreads, but compression potential might be limited without improvements on the institutional side," Veit added. Key reforms include completing the banking and capital markets unions, establishing a shared fiscal capacity, and enabling common debt issuance—steps ECB President Christine Lagarde has identified as essential for the euro.

Geopolitics and Defense Spending Complicate the Picture

The strategic landscape is also shifting. The United States, under President Donald Trump, has become a less predictable partner on trade and security, insisting that Europe must shoulder more of its own defense costs.

In response, Eurozone governments, led by Germany, are planning significant increases in borrowing to fund military spending. This new fiscal pressure adds another layer of complexity to the bond market outlook. Even short-lived political tremors, like Trump's brief threat in January to take over Greenland, caused spreads to temporarily widen before tightening again.

Will Policy and Politics Sustain the Rally?

ECB Easing and Joint Debt Hopes

Analysts widely expect the ECB to deliver another rate cut this year, a move that should help keep yield spreads stable.

Figure 2: The ESTR forward curve shows market pricing for future ECB interest rates, with traders seeing less than a 50% probability of a rate cut by 2026.

Furthermore, the EU’s pandemic-era Next Generation fund, combined with the push for higher military spending, has fueled expectations for more joint debt issuance. This prospect has supported the bonds of Southern European nations, an effect analysts believe could last through 2027.

The Hurdle to Deeper Integration

Despite these tailwinds, many economists are skeptical about greater joint issuance, primarily due to Germany's opposition.

"I think more integration will only come in a stress scenario, and we're not yet in a stress scenario," said Carsten Brzeski, global head of macro research at ING. He warned that debt-to-GDP ratios in Southern Europe could rise if the economy slows. "We can enjoy the good place, but we should be cautious in deriving any longer-term conclusions from the current state."

Italy's Shifting Role and Future Risks

The political calculus has also changed. Italy, long considered a source of instability, has become one of Europe's more politically stable countries. Meanwhile, German politics has grown more volatile, partly due to the rise of far-right, eurosceptic parties like Alternative für Deutschland.

"Politics in Italy or other Southern European countries is the part I'm least concerned about," said Rohan Khanna, head of euro rates strategy at Barclays. "What I'm more concerned about is how the market thinks about Italy in a post-NGEU world."

Barclays anticipates that spreads will trade in a tight range, concluding that there is less room for Italian spreads to fall compared to those of other Southern European countries.

Figure 3: The Italian-German yield spread and the STOXX 600 index have often moved in tandem, reflecting how tightening credit risk can align with broader market optimism.

Poland's central bank faces a difficult interest rate decision this week, as stronger-than-expected economic growth has left economists sharply divided on the next policy move.

A Bloomberg survey reveals the split: while a majority of 19 out of 32 economists expect the Monetary Policy Council (MPC) to hold its key rate at 4% for a second consecutive month, 13 are betting on a quarter-point cut. This represents the largest minority calling for a rate reduction since the current easing cycle began last May.

Surprise GDP Data Complicates Rate Cuts

The primary factor fueling the uncertainty is recent economic data. A report last week showed that Poland's gross domestic product expanded by 3.6% in 2025, surpassing forecasts. This robust performance could give policymakers a reason to delay further rate cuts.

Compounding the difficulty, the central bank will make its decision without the latest consumer price figures. Publication of the data has been postponed due to annual updates to the inflation basket.

"The MPC may prefer to wait for the March macroeconomic projection, particularly given that recently published GDP data confirmed a strong finish last year," noted Cezary Chrapek, an economist at Bank Millennium SA.

Roman Ziruk, an analyst at Ebury Technology Ltd., described the upcoming decision as "one of the hardest to call in recent months," citing the short three-week interval since the January meeting and the absence of fresh inflation numbers.

Central Bank Officials Also Divided

The division isn't limited to external analysts; members of the rate-setting committee have also sent conflicting signals.

After cutting rates by a total of 175 basis points in 2025, the path forward is unclear.

• MPC member Ludwik Kotecki suggested that the bank could resume rate cuts this month.

• In contrast, newly appointed policymaker Marcin Zarzecki indicated that further easing is not guaranteed and might only happen later.

Central bank Governor Adam Glapinski, who leads the 10-member panel, did not rule out a rate cut in February. However, he also stated there was little room left for more monetary easing throughout 2026.

The central bank is expected to announce its decision on Wednesday afternoon, with Governor Glapinski scheduled to hold a press conference at 3 p.m. in Warsaw on Thursday.

Fiscal Fears Trigger a "Truss Shock" in JGBs

Japan’s government bond (JGB) market was thrown into turmoil last month, triggering a selloff that echoed across global debt markets. The catalyst was a snap election call by Prime Minister Sanae Takaichi, who pledged to suspend a food levy for two years.

This move immediately stoked fears of increased fiscal spending, which would add to Japan's already enormous national debt. In a rout reminiscent of the 2022 "Truss" shock in the UK, when unfunded tax cuts caused a collapse in British gilts, yields on super-long JGBs surged to record highs.

With Takaichi's party poised for a potential landslide victory this Sunday, bond investors remain on high alert. A win would give her a mandate for an expansionary fiscal policy, intensifying concerns over the country's deteriorating finances.

Bank of Japan Remains on the Sidelines

While the market volatility has alarmed the Bank of Japan (BOJ), the central bank is unwilling to step in, according to three sources familiar with its thinking. At this stage, the risks associated with market intervention are seen as outweighing any potential rewards.

Japanese policymakers are caught in a difficult bind. They need to prevent a chaotic spike in bond yields while also trying to support a weak yen through threats of currency intervention. Any attempt by the BOJ to suppress long-term interest rates would directly conflict with its strategy of gradual rate hikes, a policy intended to tame inflation driven by the weak currency.

The tension was evident at the BOJ's policy meeting on January 22-23. A summary of opinions showed one board member calling for vigilance against a "one-sided steepening" of the yield curve, while another warned of high volatility in super-long JGBs.

BOJ Governor Kazuo Ueda also escalated his warnings, describing the recent pace of yield increases as "quite fast" and reiterating the bank's readiness to act only under exceptional circumstances.

A High Bar for Bond Market Intervention

Despite a temporary calm returning to markets, investors are focused on whether the BOJ will intervene if another rout occurs after the election. However, the sources confirmed that recent market moves do not meet the central bank's very high threshold for action.

The BOJ has several tools it could deploy, including:

• Conducting unscheduled, emergency bond-buying operations.

• Adjusting the mix of bonds it purchases under its quarterly plan.

• Suspending or overhauling its bond taper program, which began in 2024.

Intervention would only be considered during a panic selloff driven by speculation or a destabilizing event that forces the central bank to act as the market maker of last resort. Sources say neither of these scenarios has yet materialized. Any action would also be temporary, designed to avoid signaling a new price target for bonds.

"If bonds are being sold on speculative trading, the BOJ could see scope to intervene. But it's clear the recent rise in yields reflects market concern over Japan's fiscal policy," said Takahide Kiuchi, a former BOJ board member. "It's the government's job, not the BOJ's, to deal with the consequences of market distrust over fiscal policy."

Governor Ueda has echoed this sentiment, stating that the BOJ and the government must each play their designated roles, placing the responsibility for managing fiscal-policy-induced yield rises squarely on the government.

The High Costs of Stepping In

The BOJ's reluctance is rooted in the significant costs of intervention. Ramping up bond purchases would undo its efforts since 2024 to gradually shrink its massive balance sheet.

More critically, intervening in the bond market would risk dragging the BOJ back toward the yield-curve-control policy it abandoned in 2024. Analysts warn this could trigger a fresh wave of yen selling, as markets would interpret it as a return to monetary easing. A weak yen is already a major headache for policymakers because it drives up the cost of imports and fuels inflation.

"Trying to push down bond yields would send a conflicting message to markets at a time the BOJ is raising its short-term policy rate," said Mari Iwashita, an executive rates strategist at Nomura Securities. She added that it would also risk the BOJ's credibility by stoking fears it is directly financing government debt.

Some analysts believe the current market calm could be temporary. With investor concern over Japan's fiscal health unlikely to fade, the JGB market remains vulnerable to sudden and sharp selloffs. Domestic life insurers, historically stable buyers of super-long JGBs, are now pulling back and may even become sellers before the fiscal year ends in March.

"I'm sure policymakers are extremely nervous about the bond market now," said former BOJ official Nobuyasu Atago. "The BOJ would need to act if markets go into a free fall, but stepping in at the wrong moment could amplify panic and make things worse. Either way, it would be an extremely hard decision."

A surprise trade agreement announced by President Donald Trump has capped months of tense, behind-the-scenes diplomacy aimed at repairing a strained relationship between the United States and India. The deal, which Trump claimed would significantly lower tariffs, came after a period of public acrimony that saw both nations on a collision course.

On Monday, Trump announced that he and Indian Prime Minister Narendra Modi had reached an agreement to reduce tariffs on Indian goods to 18%. The deal also reportedly scraps a punitive 25% US duty imposed on India for purchasing Russian oil. In exchange, Trump stated that India agreed to buy $500 billion in American goods, shift its oil purchases to Venezuela, and cut tariffs on US imports to zero.

However, Modi's government has not yet confirmed these specifics, and official documentation codifying the agreement has not been released by either side. The announcement caught many officials in New Delhi by surprise, with senior bureaucrats in the commerce and foreign ministries unaware that a call between the leaders was even scheduled.

A Diplomatic Thaw Behind Closed Doors

The breakthrough follows a period of concerted effort by India to de-escalate tensions. In early September, shortly after meeting with Vladimir Putin and Xi Jinping, Modi sent his national security adviser, Ajit Doval, to Washington.

According to officials in New Delhi familiar with the private discussions, Doval met with Secretary of State Marco Rubio to deliver a clear message: India wanted to move past the recent friction and resume trade negotiations.

Doval reportedly conveyed that while India would not be bullied by the Trump administration and was prepared to wait out his term, New Delhi needed the public criticism to stop so that relations could be reset. At the time, India was reacting to Trump's public insults and the 50% tariffs he had imposed on its goods in August. The US president had described India as a "dead" economy and criticized its purchases of Russian oil.

The first sign of a thaw appeared not long after Doval's previously unreported meeting. On September 16, Trump called Modi on his birthday, praising his leadership. The two leaders spoke four more times by phone before the end of the year, steadily working toward a deal.

India's Long-Term Bet on a US Partnership

Behind India's diplomatic push was a strategic calculation that it could not afford a long-term breakdown in relations with the United States. The prevailing view in New Delhi is that American capital, technology, and military cooperation are essential to counter China and achieve Modi's ambitious goal of making India a developed economy by 2047.

Indian officials see the Trump presidency as a temporary challenge within a much longer strategic timeline. "New Delhi was never going to sever relations with Washington," noted Chietigj Bajpaee, a senior research fellow at Chatham House, pointing to the deep institutional and personal ties between the countries. However, he added that "the irrational exuberance that marked New Delhi's earlier assessments of the bilateral relationship have faded."

This approach was a response to a sharp downturn in relations. Tensions flared in May after Trump claimed credit for resolving a border clash between India and Pakistan, a claim Modi strongly rejected. In June, Modi declined an invitation to the White House, and in October, he skipped a summit in Malaysia to avoid a potentially difficult meeting with Trump.

Mending Fences After a Year of Acrimony

The arrival of new US Ambassador Sergio Gor in New Delhi in December marked a turning point. Gor, a former White House official and member of Trump's inner circle, immediately began working to restore stability. In his first public speech, he characterized the tensions as disagreements among "real friends" and announced that India would be invited to join Pax Silica, a US-led supply chain alliance.

Last week, a meeting between Gor and External Affairs Minister Subrahmanyam Jaishankar signaled further progress. Gor posted on social media that they discussed "everything from defense, trade, critical minerals, and working toward our common interests."

Alexander Slater, former head of the US-India Business Council, said the agreement "appears to conclude a difficult six-month period for US-India relations" and "removes a key impediment to what had been India's gradual but steady alignment with the West."

Balancing US Ties with Strategic Autonomy

Despite the rapprochement, India continues to assert its strategic independence. Modi's high-profile appearance with Xi and Putin was widely seen as a message to Washington that India has other powerful partners. In December, Modi gave a warm welcome to Putin, reaffirming ties with a nation that has been a key supplier of weapons since the Cold War.

India has also been diversifying its trade relationships. Last week, it secured a free trade pact with the European Union after nearly two decades of negotiations. This followed a recent trade deal with the UK, moves intended to show that India was not solely dependent on a resolution with the US. Later this month, Modi is set to host leaders Mark Carney of Canada and Luiz Inacio Lula da Silva of Brazil, further strengthening ties with other global middle powers.

The Unbreakable Economic Ties Driving the Deal

Ultimately, the powerful economic logic of the US-India partnership continues to drive both sides toward cooperation. The United States remains a critical market, receiving about a fifth of India's total exports, including a large volume of mobile phones and electronics vital to Modi's manufacturing goals.

Furthermore, US investment in India is surging. Recent months have seen major commitments, including:

• A combined $52 billion pledge from Amazon.com Inc. and Microsoft Corp. in December.

• A $15 billion investment in data centers announced by Alphabet Inc.'s Google in October.

"The larger geopolitical factors or strategic factors that bind Indian and the US together are still in place," said Milan Vaishnav of the Carnegie Endowment for International Peace. "India requires a great amount of capital of investment of technology transfer... So the US is critical."

The End Of The Last Nuclear Constraint

A Treaty Hollowed Out Before Its Expiry

China’s Role In Shaping US Calculations

Strategic Shifts In Beijing

The Risk Of A Three-Way Arms Race

A Breakdown Of A Long-Standing Architecture

An Uneasy Global Outlook

A Weak Start Revealed By Official PMI Data

Non-Manufacturing Sectors Also Lose Momentum

Beyond Seasonal Factors

Exports Carry The Load As Domestic Demand Falters

Shifting Growth Priorities In Beijing

Policy Expectations And Lingering Constraints