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A surge in Eurozone government borrowing costs as a result of Germany’s planned defence spending spree will intensify debt pressures on other countries in the bloc and could make it harder for them to mount borrowing campaigns of their own, investors have warned.
The shift by the region’s biggest economy away from its historic reluctance to borrow — which in the past has led to a scarcity of Bunds and sub-zero yields — to a “whatever it takes” plan for military and infrastructure spending is being felt across the bloc’s financial markets.
Ten-year Bund yields have risen to close to 3 per cent this month for the first time since a global bond sell-off in 2023. That has pushed other government borrowing costs higher, thanks to German debt’s role as the de facto benchmark for the bloc’s market, prompting warnings about the impact on the finances of more heavily-indebted economies.
“The rise in yields could eclipse fiscal space for an increase in defence spending outside of Germany,” in particular in France and Italy, said Sören Radde, head of European economic research at hedge fund Point72.
French 10-year yields have risen above 3.6 per cent this month, their highest in more than a decade and topping levels reached at the height of its political crisis last year. Italy’s yields touched 4 per cent for the first time since last July.
A simulation by Point72, factoring in higher defence spending as well as higher yields, shows that without spending cuts elsewhere, or a boost to growth, Italy’s debt-to-GDP ratio could rise to 153 per cent by 2030, and France’s to 122 per cent, from around 140 per cent and 115 per cent respectively.
However, if countries cut spending or raise taxes, or if they receive a boost to growth as a positive spillover from Germany’s spending splurge, then “unstable paths can be avoided”, Radde added.
Spreads — the additional borrowing costs countries pay relative to Germany — have so far remained broadly steady, signalling that markets are not yet worried about the impact of higher borrowing costs on governments whose finances are shakier than Berlin’s. The euro has also strengthened, underlining the optimism over the boost to economic growth that helped drive yields higher.
But such fiscal strains could begin to appear if other euro area economies follow Germany’s lead in borrowing to spend more on defence, some fund managers warn.
“I think spreads will start to widen also, as there is more stress put on the system,” said David Zahn, head of European fixed income at asset manager Franklin Templeton. “The countries that have higher debt to GDP and higher yields already . . . it will be harder for them to borrow.”
The result could be greater divergence between different Eurozone countries’ borrowing costs as their finances come under greater scrutiny.
“Individual country fundamentals will matter a lot more,” said Connor Fitzgerald, a portfolio manager at US asset manager Wellington Management, adding there should be a “general detachment” of borrowers from each other.
Investors have been steeling themselves for months for the increase in issuance. Bund yields have been trading above equivalent duration euro interest rate swaps for the first time in history, reflecting investor anticipation of greater issuance.
“One could argue that European government bond yields have been too low for some time, compared to other global bond markets, as a result of the self-imposed fiscal discipline of Germany,” said Gareth Hill, a fund manager at Royal London Asset Management. Germany’s move “goes some way to redressing that balance”.
Some fund managers also say that while there is anxiety over the quantity of Bunds likely to be issued, this should not necessarily pull demand away from other countries’ debt.
“It’s not as if there’s a shortage of funding for this [extra Germany spending],” said Simon Dangoor, head of fixed income macro strategies at Goldman Sachs Asset Management.
“German households have plenty of savings they can direct to financing this, without undermining demand for other Eurozone bond markets,” he said, although he added there were other risks from the broadly higher yields, as other countries could more easily “tip themselves into a debt sustainability issue”.
Investors also argue that greater liquidity in Bunds could bolster efforts by Eurozone policymakers to present the euro as a rival reserve currency to the dollar.
A major hindrance to greater accumulation of euros by global central banks has been a much smaller and less uniform sovereign debt market — relative to the vast US Treasury market — and a shortage of debt with the highest credit rating.
“You could create a useful Eurozone triple-A reserve asset [from the extra Bunds issuance],” said Dangoor.
