The dramatic rise in Germany’s financing costs this week is far from a rejection of Friedrich Merz’s fiscal bazooka, investors say, with many believing the chancellor-in-waiting’s spending plan can boost growth without stretching Berlin’s finances beyond a sustainable level.
German Bunds had their biggest one-day sell-off in decades on Wednesday as markets adjusted to a dramatic change in German fiscal policy, and a massive increase in debt issuance, following Merz’s “whatever it takes” plan to spend on defence and infrastructure.
Despite settling down at the end of the week, the 10-year Bund remained elevated above 2.8 per cent on Friday, having started the week below 2.5 per cent.
“German authorities have finally woken up to the fact that they needed to take drastic actions to revive their economy” and bolster their defence, said Nicolas Trindade, a senior portfolio manager at Axa’s investment arm. “This is positive for growth over the medium term, and Germany definitely has enough fiscal space to accommodate this very large extra spending.”
Economists as early as Thursday morning started to revise up their growth forecasts. BNP is now forecasting that German GDP will rise by 0.7 per cent this year and 0.8 per cent in 2026, instead of a 0.2 per cent and 0.5 per cent increase. The uplift in expectations also helped drive German stocks to a record high on Thursday.
The rise in Bund yields and stock prices was “an endorsement of the positive impact this policy shift will have on German growth”, said Gordon Shannon, a fund manager at TwentyFour Asset Management.
Yields rose as traders moved to trim their expectations for European Central Bank rate cuts on the stronger outlook, even before Thursday’s meeting took the Eurozone benchmark rate down a quarter-point to 2.5 per cent. Traders are now fully pricing in only one further quarter-point cut, according to levels in swaps markets.
The other major factor in the jump in yield, investors said, was the massive rise in Bund issuance, an asset that sets a benchmark for Eurozone debt prices but has often been in short supply due to Germany’s “debt brake” limiting government borrowing.
That scarcity — also due to central banks holding a large proportion of the available stock — is one reason Bund yields have traded below zero for prolonged periods over the past decade.
Traders began betting in earnest on higher Bund issuance last year as speculation rose over debt brake reform, taking 10-year Bund yields above the rate for euro interest rate swaps for the first time as investors braced for more supply.
Higher yields reflect the risk that the broader Eurozone debt market might have “difficulty” in absorbing the supply of issuance “if the new fiscal headroom is indeed utilised”, said Felix Feather, economist at asset manager Aberdeen.
It was not, he said, driven by a perceived increase in credit risk. “The possibility of Germany defaulting on or restructuring its debt is not a concern for us at this point,” he said.
This was miles away, investors said, from the experience of the UK in 2022, when Liz Truss’s ill-fated “mini” Budget sparked a gilts crisis. A similar extreme scenario in Germany would have ramifications across the euro area.
“Germany is the backbone of the Eurozone. If the German budget gets out of control, the Euro will be toast,” said Bert Flossbach, co-founder and chief investment officer of German asset manager Flossbach von Storch.
The country’s light debt burden — with debt amounting to around 63 per cent of GDP, versus close to or above 100 per cent for some other big economies — means such a scenario is viewed as highly unlikely.
There is more concern among investors about the potential repercussions of the shift higher in borrowing costs for other Euro area countries that are already much higher leveraged.
The spread between German yields and those of other Eurozone borrowers such as France and Italy remained stable this week, a sharp contrast to historic moments of stress such as the Eurozone debt crisis. But the rise in yields in lockstep with Germany will still put pressure on countries with larger debt burdens.
UK bonds were caught up in the sell-off, with the 10-year yield above 4.6 per cent on Friday, up from its low last month of below 4.4 per cent, as it comes only weeks before the government makes a statement on the public finances on March 26.
The rise in yields put more pressure on chancellor Rachel Reeves to “deliver tax hikes or spending cuts to stay within her fiscal rules”, said Mark Dowding, chief investment officer for fixed income at RBC BlueBay Asset Management.
A key factor in where Bunds go from here will be whether the hoped for German economic growth emerges.
In one of the most optimistic outlooks, German economic think-tank IMK predicted that the German economy over the medium term may return to growth rates of up to 2 per cent — a rate of expansion slightly above the 1.8 per cent per year seen in the 15 years prior to the pandemic.
Analysts also warn that a debt-funded investment spree will not be sufficient to overcome Germany’s persistent growth crisis, which many attribute to deeper issues like an ageing workforce, bureaucracy and an outdated industrial structure.
The export dependent manufacturing sector is also hit hard by geopolitical tensions. “Wider deficits alone won’t solve any of [those challenges],” said Oliver Rakau, chief Germany economist at Oxford Economics.
But other analysts are more positive. Bank of America called the fiscal stimulus a “game changer” for German growth that, paired with the higher bond issuance, pointed to a “meaningfully higher” forecast for the 10-year Bund yield than it had previously envisaged.
“Bund yields are not going up out of fear, because Germany has plenty of fiscal space,” argued Mahmood Pradhan, head of global macro at Amundi. “The markets are treating this as a growth positive outcome.”