Borrowing costs in Italy and Greece are rising due to interest rate fears in the eurozone

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Borrowing costs in Italy and Greece hit multi-year highs on Friday, as investors were rocked by a dovish meeting of the European Central Bank that is increasing pressure on the finances of Europe’s most indebted countries.

The yield on the 10-year Italian bond rose to 3.75 percent, its highest level since 2014. The 10-year Greek bond rose 0.23 percentage points to 4.28 percent, beating the level it was at the peak of the year Covid-19 pandemic reached.

The ECB on Thursday confirmed plans to end its asset purchase program and raise interest rates next month for the first time since 2011, hinting that more aggressive rate hikes could follow later in the year.

The move to tighten monetary policy as the central bank seeks to rein in record-high inflation has reignited investor concerns about the ability of weaker eurozone members to bear their massive debt burdens without ECB support.

Spanish and Portuguese debt were also hit, while the sell-off extended to European bank stocks, many of which are facing severe debt sell-offs due to their holdings in government bonds.

Italy’s main stock index fell 5 percent, led by the banking sector. Lenders UniCredit and Intesa Sanpaolo lost 9 percent and 7.6 percent, respectively.

Crucially, ECB President Christine Lagarde on Thursday said the central bank could introduce a new tool to avoid “fragmentation” of the euro area by keeping government borrowing costs under control, but gave few details. She also reiterated that the central bank could reinvest the proceeds from maturing bonds it holds to stave off bond market stress.

“There’s a lot of doubt that reinvesting can really help when things go wrong,” said Rohan Khanna, rates strategist at UBS. “Before the meeting, there was some hope that they were working on some sort of new facility, but Lagarde hasn’t told us anything new. The big question clients keep asking is who will buy Italian bonds if the ECB backs down.”

The euro continued to decline on Friday, falling 0.9 percent against the dollar to a three-week low of $1.052. The currency initially rose after Thursday’s ECB announcement but gave up gains as the market shifted focus from the prospect of higher interest rates in the euro-zone to renewed tensions in the bond market.

The gap between Italian and German 10-year bond yields, a closely watched gauge of market stress, widened as much as 2.27 percentage points on Friday, the highest since May 2020.

Khanna said some investors had speculated that the ECB could be forced to re-enter markets if that spread hit 2.5 percentage points – a level that provoked a central bank reaction in the early stages of the pandemic.

“After what we saw yesterday, many people are wondering if the level at which the ECB is stepping in and saving the day is now higher than previously thought,” he said.

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