Contrarians bet against 'sea change' in European bond markets
Germany has announced a new fiscal bazooka but some investors are betting it’ll be a damp squib.
Germany’s shock announcement that it would increase defence and infrastructure spending by around €1trn roiled European bonds last week, triggering the steepest rise in 10-year Bund yields in decades. But even as economists pronounced a watershed moment for Europe that should boost growth considerably, some investors have been quietly taking the other side of the trade and buying up European bonds.
Those contrarians highlight a range of factors that could yet weigh on government bond yields: from uncertainty as to when Berlin’s spending kicks in; to the potential for US tariffs to act as a counterweight to growth; to whether the German government can ram its stimulus package through parliament at all.
"I’m sceptical we will see [debt] issuance to the extent that’s being talked about,” said Mike Riddell, a senior portfolio manager at Fidelity International, which manages US$893bn in assets.
“We have been exiting eurozone underweights and entering bullish positions on the back of these moves, as [we] don’t think the size of the selloff is justified.”
German chancellor-elect Friedrich Merz’s pledge last week to do “whatever it takes” to increase defence and infrastructure spending caught markets unaware, leading to a dramatic repricing in European government bonds. Strategists at Goldman Sachs hailed the announcement as a “sea change for German yields”.
BNP Paribas estimated Germany's fiscal plans could translate into an increase of about €140bn in net bond issuance between now and 2028, which could lead the 10-year Bund yield to rise to between 3.70% and 4.20%. The 10-year yield was about 2.90% on Tuesday, according to LSEG data, up from 2.50% a week earlier.
Nevertheless, some analysts and investors have cast doubt on the theory that a structural shift is underway in European debt markets, highlighting various issues that complicate the outlook.
Political hurdles
The first hurdle is political. Merz has sought to pass the spending plans before the end of the current parliament later this month. But the chances of him securing the two-thirds' majority needed to do this took a blow on Monday after Germany’s Green Party said it wouldn’t support the draft law. Analysts said passing the law would prove still harder in the next parliament.
“The risk of failure has increased,” Carsten Brzeski, global head of macro research at ING, wrote in a note on Tuesday called “German politics experiences another disappointing 24 hours”.
“Failure, however, is almost not an option as it would not only potentially end the current coalition talks … but could eventually even push Germany into a political crisis,” Brzeski said.
Deutsche Bank economists said “considerable execution risk” is one reason they haven’t raised their economic forecasts following last week's news, even though their base case is for the reforms to pass, albeit not in a smooth fashion.
“At this point, failure to pass the proposed debt brake reform would not just severely limit the scope of a fiscal expansion in the next four years. It would also undermine the next government's credibility,” the economists wrote.
Tariff threat
While politics may represent the most obvious barrier to German yields marching higher, analysts note there are other reasons to believe the recent market moves could be overdone. Infrastructure spending, for one, typically takes a long time to materialise given the need for governments to identify and commission projects, pushing back any increase in debt issuance.
On defence spending, Riddell noted that countries may not use the extra spending headroom even if fiscal limits are relaxed. “Many countries are underspending versus current limits. And there’s a reasonable chance the Russia-Ukraine war ends soon, reducing the urgency of major defence spending too,” he said.
The prospect of US tariffs also looms large over the continent. Barclays' strategists said “it is hard to imagine why Europe would be spared” from tariffs following the Trump administration’s recent proposal to tax goods from Canada and Mexico.
“In the near term, if both tariffs and fiscal announcements materialise, the initial negative impulse would dominate – by quite some margin,” the strategists wrote in a note on Monday. "In this tug-of-war between near-term pessimism and medium-term optimism, last week's price action was firmly in favour of the latter; but does that add up?"
Camille de Courcel, head of developed markets rates strategy and economics for Europe at BNP Paribas, expects bond markets to remain volatile for some time because of the uncertainty over the disbursements of Germany's planned spending increases and the lack of clarity over tariffs.
"If implemented, tariffs could more than offset any positive impact you have on growth from the announcement in Germany," she said. "For the European Central Bank there is still a lot of uncertainty over what is going to happen this year and how that will impact growth and inflation."
