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Bond Vigilantes Are Ready to Give Germany a Pass on Extra Debt
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Bond Vigilantes Are Ready to Give Germany a Pass on Extra Debt
Alice Gledhill
5 min read
(Bloomberg) -- As fears over Europe’s anemic growth and defenses swirl, investors have a clear message for Germany ahead of its election: There’s room to borrow more.
It’s an unusual stance in an era where governments globally are under scrutiny from so-called bond vigilantes for excessive spending and vast budget deficits. And it’s a tough sell in a country that has long prided itself on fiscal rectitude.
But Germany’s decades of self-discipline have left the country with a limited debt burden, giving it plenty of borrowing power at a time when the economy desperately needs stimulus. And far from punishing the government for borrowing more, investors would welcome increased issuance given the dearth of top-quality bonds in Europe for fund managers to buy.
There are signs that German politicians increasingly recognize the need for greater borrowing, especially to pay for defense. It’s unclear, though, how far any new government will go in loosening the constitutional limit on borrowing, a vestige of the 2008 global financial crisis, to spend more freely.
“There is still no clear majority for wholesale reform,” said Elliot Hentov, global head of macro policy research at State Street Global Advisors. “The irony is that one of Germany’s remaining big competitive advantages is the country’s fiscal space.”
Germany’s economy shrank in 2024 for a second consecutive year, only the second time that’s happened since 1950, because of years of underinvestment, the loss of cheap Russian gas and a long-running slump in China, a key trading partner.
Meanwhile, the Trump administration is pressing the European Union to spend more on defense rather than depend as much on the US to counter the looming threat from Russia.
Uncertainty Reigns
For now, Germany’s debt brake limits structural budget deficits to 0.35% of gross domestic product.
The conservative CDU/CSU alliance, which is expected to garner the most votes in Sunday’s election, favors keeping the debt brake intact, though its leader Friedrich Merz has signaled he would be open to adjusting it. Polls also show public opposition to loosening the limit has eased and the Bundesbank is planning to set out its own suggested changes after the vote.
Politicians should consider transitioning toward a new economic model rather than attempting to resuscitate the old one, according to Sonia Renoult, senior rates strategist at ABN AMRO. “Doing so is crucial to restoring confidence among businesses, consumers, and investors,” she said.
From Germany’s perspective, now might be a good time to kick off additional bond issuance. The nation’s outright borrowing costs — at about 2.54% for 10-year bunds — remain the lowest in the euro area, and stand to decline further with the European Central Bank expected to deliver additional interest-rate cuts this year.
Investors interviewed by Bloomberg last year said the market could digest additional debt equivalent to at least 5% of output, roughly €220 billion, over time, or as much as €400 billion extra over the next decade.
That may necessitate higher yields to attract price-sensitive private investors, given that the ECB is no longer hoovering up government debt as it did for much of the past decade. In preparation for further issuance, investors have pushed up yields on government bonds relative to interest-rate swaps, a widely watched benchmark.
Societe Generale SA strategists including Adam Kurpiel estimate the 10-year yield would increase by an average of about 30 basis points for every additional €100 billion of net supply.
But so long as more debt funds investment and generates growth, markets will be amenable, said Ales Koutny, head of international rates at Vanguard.
“If it’s just like France, where they have chosen to do that for day-to-day spending, that’s a problem,” Koutny said. The US, with its vast borrowing and robust growth, offers a counterexample, he said: “If you can increase growth by a percentage point or more, suddenly all these concerns go away quite quickly.”
An increase in the supply of German debt is likely to find demand from European pension funds, insurers and banks who need high-quality, long-term assets. Europe has long lacked a market liquid and big enough to compete with the $28 trillion in US Treasuries outstanding, the world’s undisputed safe asset. Alongside Germany, the Netherlands and Luxembourg are the euro area’s only countries that are graded AAA from all three major ratings firms.
A regular auction of 10-year German bonds drew healthy demand on Wednesday, with investors offering to buy more than 2.75 times the amount of sold.
What Bloomberg strategists say...
“If bonds follow the kind of template set when expectations for surprise extra borrowing jumped during the pandemic, Germany’s 10- and 30-year yields will rise sharply higher.”
—Ven Ram, Cross-Assets Strategist, Dubai
It’s not just Germany that stands to benefit from fiscal loosening in Berlin. Despite its recent stagnation, the country remains the largest economy in Europe and higher spending could ripple through the bloc.
“If Germany starts to be a little bit less tightfisted when it comes to spending, that’s going to have a positive impact on the fiscal thrust in Europe over the next few years,” said Mathieu Savary, chief European investment strategist at BCA Research.
--With assistance from Kamil Kowalcze and Greg Ritchie.
(Updates to specify geographic region in 17th paragraph.)
