The Fed Isn’t the Only Thing Dragging Down the S&P 500. It’s Also Europe.

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Christine Lagarde, president of the European Central Bank.

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The S&P 500 isn’t skidding into a bear market simply because of the growl of a more aggressive Fed. European bond spreads are pushing the index down, too, a new computer model shows.

The widening difference between bond yields in different countries within the euro area affects the S&P 500 in two ways. First, European markets are important for companies in the index. Second, the widening of spreads between European government bond yields threatens the stability of global economy, which makes investors less willing to take risk.

“The S&P has become increasingly sensitive to European government bond spreads,” said Huw Roberts, director of analytics at Quant Insight, which develops an algorithm of macro factors to explain—and predict—stock market levels. “Inflation is undoubtedly hugely important. But it’s not the only game in town.”

A selloff in German, French, and Italian bonds started last week after the European Central Bank pledged to raise rates next month for the first time in more than a decade. It plans to lift the key rate a quarter-point in July and possibly a half-point in September if conditions warrant it.

New U.S. inflation numbers, also out last week, came in higher than economists had forecast, leading traders to price in two half-point hikes from the ECB by October.

When one country commands higher bond yields than its neighbors, financial conditions tighten there.

That means that the ECB’s rate moves punish some economies more harshly than others, and the ones most hurt are the ones that were weakest to begin with. It also creates instability, since the result is that interest rates are too high for some countries and too low for others.

On Monday, the bond selloff intensified. The German 10-year yield was 1.55%, up from 1.36% on Thursday. The Italian 10-year yield climbed to 4%, the highest since 2014, compared with 3.37% last week.

Not only were yields rising quickly, but they were rising much faster in countries like Italy and Greece than in Germany. The ECB has said it is working on a tool to reduce the spreads between countries, but hasn’t provided any details of how it might work.

The rising yields are a grim reminder of the European sovereign debt crisis a decade ago. At the time, Greece was nearly forced to abandon the euro by spiraling borrowing costs on international debt markets that raised the prospect of default. That crisis was averted only after then-ECB President Mario Draghi promised to do “whatever it takes” to preserve the currency bloc.

“If you’re not paying attention to events in Europe, then you’re missing an important part of the jigsaw,” Roberts said.

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