Storm in the European Government Bond market
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Article Type
Insights
Topic
Opinion
Published
March 07, 2025
Read time
5 mins
Author
Irina Kurochkina, CFA
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This week European financial markets experienced a shockwave after an agreement by the likely coalition of the next German government to significantly increase fiscal spending on defense and infrastructure. German 10-year yields jumped 30 basis points in a single day after the announcement, the biggest increase since 1990 following the demise of the Berlin Wall.

 

For years, investors have voiced concerns about limitations on German economic growth due to the debt break rule that has been enforced since 2009 to prevent the country from running a structural deficit of more than 0.35% of GDP. Germany’s fiscal prudence was long considered unchangeable and was one of the key factors behind the country’s indisputable safe-haven status and AAA credit rating. The government’s sudden shift toward greater fiscal flexibility triggered a dramatic sell-off in German government bonds, setting off a domino effect across the European rates market. As a result, financing costs across the EU member states rose by an average of 20 basis points. The most profound impact was observed in the medium- and long-term segments of the yield curve, reflecting fears of increased debt issuance not only by Germany but also by other European countries that may ramp up defense spendings.

 

“Game-changer” in German fiscal policy

In the run-up to the dramatic move in European yields, geopolitical news had already been contributing to increased market volatility for weeks. After the eyebrow-raising speech by US Vice President Vance at the Munich Security Conference in mid-February, European leaders reacted with unusual speed to make new defense commitments and ensure European alliances in the face of reduced military backing from the US. These efforts intensified after the contentious discussion in the Oval Office between US President Donald Trump and Ukrainian President Volodymyr Zelensky on 28 February, highlighting the growing divergence between the US and the EU in their views on security on the European continent. Just a few days later, the European Commission reacted by putting forward the proposal of €150 billion in loans to states for increased defense spending, while also suggesting exempting as much as €650 billion of security expenditure from budget rules for the next four years. The existing EU’s rules limit members’ debt-to-GDP ratio to 60% and budget deficit to 3%. Germany, which has traditionally opposed proposals allowing for more fiscal flexibility, does not appear to be resisting the ambition this time. While the EC proposal still needs approval from the state leaders and will likely face challenges from some EU members, the announcement caused European yields to rise due to the expectation of fiscal loosening and the risk of a large amount of new bond issuance by EU bodies.

 

Almost simultaneously with the EC announcement, the Bundesbank voiced a recommendation that Germany should create more than €200 billion in extra fiscal space for infrastructure and military needs by deviating from its constitutional borrowing limits. These developments were already putting upward pressure on the German yield curve, but then, on the evening of 4 March, a major political announcement caught the market by surprise. Chancellor-to-be Friedrich Merz outlined an agreement with the leaders of the conservative CDU/CSU and social-democratic SPD to significantly increase fiscal spending, aiming to establish a €500illion infrastructure fund and exempt defense spending above 1% of GDP from the debt break rules. At the press conference unveiling the bill, Merz stated that the country must do “whatever it takes” when it comes to defense in times of new threats to freedom and peace in Europe.

 

The following reaction in rates markets showed that investors had not expected the decision from future coalition partners to come so quickly and be so impactful. While there is still high uncertainty over the final shape and size of any possible changes, the mere idea of fiscal loosening in Germany had a bazooka effect on financial markets and will keep investors on their toes in the coming period.

 

Risk assessment by the ECB

In the midst of the storm in the European government bond market and a continued flood of geopolitical news, the ECB held its monetary policy meeting on 6 March. The Governing Council lowered the three key rates by 25 basis points, bringing the deposit rate to 2.5%. They cited that the disinflation process is “well in track” while the economy is facing various challenges. Updated headline inflation projections by the ECB staff were broadly unchanged, except for a small upward revision for this year: 2.3% in 2025 (vs 2.1% previously), 1.9% in 2026, and 2.0% in 2027 (vs 2.1%). At the same time, new projections showed weaker GDP growth: 0.9% in 2025 (vs 1.1% previously), 1.2% in 2026 (vs 1.4%), and 1.3% in 2027. The downward revisions for 2025 and 2026 were attributed to lower export volumes, weakness in investments, and high trade policy uncertainty. The ECB’s assessment of risks to growth remained tilted to the downside.

 

At the press conference following the monetary policy announcement, president Lagarde received multiple questions about the announced fiscal changes in the eurozone. She acknowledged that the plans by the European Union and the next German coalition would overall be positive for economic growth in Europe, as they would increase the aggregate demand. However, she made it clear that it is too early to provide a proper assessment of the impact on GDP or inflation, as the final outcome will largely depend on details such as where defense purchases are made and what the timelines for those spendings are. She also emphasized that the role of the ECB is to deliver on its inflation mandate, meaning it has no role in financing efforts, and effectively rejecting the idea that monetary policy in the short term can be influenced by political developments.

 

Outlook on yields remains constructive

In the aftermath of the fiscal bazooka announcements, markets adjusted their expectations, now pricing in only two additional rate cuts by the ECB this year, down from three at the start of March. Following the ECB meeting, benchmark 2-year and 10-year German yields ended the day at elevated levels of 2.2% and 2.8%, respectively. We believe that the combination of current valuations and a fragile fundamental outlook for the coming year still makes the bond investments attractive, both in the short end of the yield curve and up to 10-year maturities. Given the monetary and fiscal expectations, we see further room for the yield curve to steepen and, therefore, maintain an underweight view on the long end of the curve.

 

In the long term, the potential increase in debt across major economies suggests a possibility that future financing costs will be higher than originally projected. However, we still need further details on the final proposal by the EU and the new German coalition to fully assess their impact on GDP, inflation, and debt sustainability. Currently, there is still no clarity on whether the announced plans will be approved for execution and through what channels the political promises will be turned into real policy action. In the short term, economic growth is not expected to benefit from additional spending, as uncertainties – such as policy changes and the global tariff war – continue to weigh on business sentiment and consumer confidence. Therefore, we believe it is too early to adjust our outlook on European yields, as the imminent headwinds to economic growth are likely to drive yields lower over the course of the year.

Disclaimer

Author

Irina Kurochkina, CFA
Portfolio Manager

Irina Kurochkina, CFA, is a portfolio manager in the fixed income, LDI and investment solutions team with a focus on sovereigns.

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