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US Treasurys are the biggest risk to global markets right now, the European Central Bank’s vice president warns

Key Points
  • Yields on U.S. Treasury bonds have been steadily rising to multi-year highs in anticipation of interest rate hikes by the Federal Reserve.
  • Rising bond yields and a strengthening dollar have led to higher volatility in emerging markets.
  • Market watchers fear the building sell-off in emerging markets is disrupting the synchronized global growth story of the last year.
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Hope new Italian government will respect European fiscal rules, says ECB's Constancio

A potential correction in financial markets is what keeps the European Central Bank's vice president awake at night, he said Thursday, discussing the ECB's recently released bi-annual financial stability report (FSR).

"The main risk in the FSR is a correction in financial markets, particularly in the bond market," Vitor Constancio told CNBC's Annette Weisbach in Frankfurt. And this would be "coming presumably from the U.S. where indeed the 10-year bond yields increased and are touching 3 percent, " he said.

"That has consequences of course for the exchange rate of the dollar, which then impacts emerging markets. That is the main risk for financial stability worldwide, with consequences for (the) euro area too."

Yields on U.S. Treasury bonds have been steadily rising to multi-year highs in anticipation of interest rate hikes by the Federal Reserve as part of its policy normalization plans. Consequently the month of May has seen the U.S. dollar hit a series of 2018 highs, up 4.2 percent since the first quarter's end against a basket of six major currencies.

Emerging market pain

A stronger dollar means more expensive borrowing and financing for emerging markets, particularly those with a high amount of dollar-denominated debt. And market watchers fear that the building sell-off in emerging markets is disrupting the synchronized global growth story of the last year.

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ECB's Constancio: Central banks will take years to reduce balance sheets

"We are concerned with this overall impact that can trigger more financial instability," said Constancio, a Portuguese economist who has held the position of vice president since 2010, becoming one of the longest-serving members in the central bank's history. He will depart the bank this month.

"Fortunately," he added, "the situation in the euro area is much more resilient than any time before the crisis." He attributed this to euro area countries enjoying primary surplus on their budgets and a significantly strengthened banking sector.

The ECB's FSR concluded that the financial stability environment in the euro area has "remained favorable," but pointed to risks including shard falls in global asset prices, weak bank profitability, liquidity risks in the investment fund sector, and concerns over public and private indebtedness.

Italy concerns

The issue of debt in the euro area is particularly in focus for Italy, where two populist parties leading a new coalition government — the Five Star Movement (M5S) and Lega — threaten to shirk EU fiscal rules.

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ECB's Constancio: 'Toolkit is there' for signs of stress in economy

Asked if he was concerned about Italy and spillover effects of a euroskeptic-led government, Constancio described his approach as one of watching and waiting.

"We are watching, observing and analyzing the developments in Italy of course, markets are reacting," he said, pointing to recent spikes in Italy's 10-year bonds while adding that the central bank would have to wait for implementation of measures by the new government to see what policies would then be applied.

The heads of M5S and Lega have proposed cutting taxes, boosting public spending and establishing a guaranteed basic income, making other European leaders nervous about their adherence to the euro area's budget deficit rules. The third-largest economy in the euro zone faces a heavy public debt load and a raft of non-performing loans in its banking sector.

On Wednesday, the European Commission warned the incoming government that it should continue to cut Italy's public debt. The country had a debt-to-GDP ratio of 131.8 percent in 2017 and a budget deficit of 2.3 percent in the same year. EU rules entail a budget deficit limit of 3 percent, which M5S and Lega have criticized as hampering growth.

"I hope that Italy will continue to respect European rules regarding fiscal policy, because in the end it is in their own interest," the vice president said. "Otherwise markets will continue to react as they have reacted, and so there is a challenge there."

Stocks in Italy advanced Thursday as Italian President Sergio Mattarella gave his approval for the populist coalitions' pick for prime minister — a little-known law professor called Giuseppe Conte — to lead the government, potentially ending months of political gridlock. Italy's FTSE MIB index opened 0.5 percent higher on the news.

—CNBC's Holly Ellyatt contributed to this article