How Germany’s spending boost is upending world bond markets

London/Singapore — A sea change in German fiscal policy is rapidly transforming global bond markets as it is expected to increase the pool of top-rated, safe-haven debt and propel Germany into a new era of structurally higher government bond yields.

The parties hoping to form Germany’s next government agreed last week to create a €500bn infrastructure fund and overhaul borrowing rules.

In response, Germany’s bond market suffered its biggest weekly sell-off since the 1990s, pushing 10-year bond yields up more than 40 basis points to about 2.9%, as investors anticipated a jump in bond sales to fund increased spending.

Even considering road bumps such as securing parliamentary support to pass reforms, many suspect the end result will be a lasting shift for German government bonds, the euro area benchmark.

Several banks believe 10-year bund yields could now reach 3%, more than 20 bps above Monday’s trading. The German 10-year yield has not sustained a level above 3% since the global financial crisis and the government’s 2009 introduction of a “debt brake” to balance the books. It fell below 0% between 2019 and 2022 and ended last year just above 2%.

But investors are suddenly facing the prospect of a more dynamic German economy with higher growth and higher borrowing.

“To suddenly have this fiscal impulse from Germany, a paradigm shift, it makes our clients question the region completely differently,” said Kal El-Wahab, head of Europe, Middle East and Africa linear rates trading at BofA, who noted that for much of his 20-year-long career the outlook for Europe’s economy had been sluggish.

El-Wahab said it was too early for large structural portfolio shifts to take place, but trading activity so far showed there was conviction about the European growth story.

Germany’s plans and increased European defence spending increase potential GDP growth by 1.5% in Germany and 0.8% in the eurozone by 2030, BNP Paribas estimates.

Meanwhile, Commerzbank says the measures could easily add up to more than €1-trillion of additional debt over the next 10 years, significantly boosting the supply of top-rated bonds sought after by investors globally.

Overall, Germany’s AAA rating benefits from its high fiscal flexibility, S&P Global Ratings said.

“This fiscal awakening is a push further into collateral abundance with far-reaching consequences for bunds and their place in the European government bond market,” said Barclays head of rates strategy Rohan Khanna.

Khanna said Germany’s market had been “plagued by scarcity” with negative net bond issuance for seven of the past 10 years, when taking central bank purchases into account.

Germany’s shifting price dynamics have rippled across Europe and beyond, because if global bond investors can earn nearly 3% on German debt, they will expect higher yields elsewhere.

French and Italian borrowing costs also jumped by about 40 bps each last week, worse news for their more highly-indebted governments.

US Treasuries largely went their own way as they grappled with slowing US growth, but British 10-year gilt yields were up almost 20 bps to seven-week highs and Japan’s already-rising 10-year yield touched 16-year highs of 1.53%.

“Japanese government bonds [JGBs] will effectively need to compete with bunds in yield,” said Ales Koutny, Vanguard’s head of international rates.

“We now see 2% in 10-year JGBs as a realistic target, as capital flow out of Europe will be meaningfully jolted by this change in German policy.”

Life insurers, among the most significant Japanese investors, arrange their assets to match liabilities and are not opportunistic traders, while they and others tend to hedge currency exposure, meaning a 10-year bund with a 2.9% yield may only earn about 1.2%, less than a 10-year JGB but more than about 0.7% on a hedged 10-year Treasury.

But, with nearly ¥430-trillion in assets and about a quarter of that abroad, small changes in allocations can have a meaningful impact on foreign markets, particularly European ones that have faced Japanese outflows.

Goldman Sachs estimates that German yields could rise even further with the spending plans implying a potential range of 3%-3.75% for bund yields.

“There may be some risks of capital outflows from the US … because higher yielding bunds would make them a peer of treasuries,” said Amundi Investment Institute head Monica Defend.

Nuveen global investment strategist Laura Cooper cautioned that US tariff uncertainty could temper the rise in German yields though momentum remained behind a move higher.

“Historically, when you come from below fair value you don’t just hit that, you can go as much as 50 bps higher,” said Aviva Investors senior economist Vasileios Gkionakis, estimating fair value for German yields at 3.1%-3.2%.

“We can put conditions on how quickly change will come from Germany but right now I cannot believe the headlines I’m reading.”

Reuters