Germany’s new fiscal bazooka lit a fire under European debt markets last week, sending euro derivatives volumes soaring to record heights while inflicting heavy losses on many investors – and delivering bumper profits for others.
Ten-year German bond yields registered their largest one-day rise in decades on Wednesday as investors dumped the securities in response to Berlin outlining plans to remove its debt brake and increase spending on defence and infrastructure by nearly €1trn over the next decade.
Many turned to the ultra-liquid Bund futures market in a mad scramble to reshuffle exposures. A net 5.4m of these contracts changed hands on Wednesday and Thursday, according to LSEG data, making it comfortably the busiest two-day trading period on record.
A record US$3.9trn in over-the-counter euro interest rate derivatives also traded over the course of the week, according to trade repository data collated by ISDA, as investors adapted to a new era for European debt markets.
“Whenever you get these types of shocks, you get the initial macro hedging in futures. When the dust settles you tend to see more derisking and deleveraging coming to the market in the following sessions,” said the head of European rates trading at a major bank, who characterised market conditions so far as “fairly orderly” with “pretty good” liquidity.
“We’re now watching to see if there are any casualties. That can then force a derisking in the system that triggers price action that has a bigger impact on liquidity. When these moves happen there tends to be winners and losers," the trader said.
German chancellor-elect Friedrich Merz said he was prepared to ease the country’s famously draconian spending rules after his centre-right Christian Democratic Union party won the most seats in late February's parliamentary elections. But the sheer size and abruptness of Berlin’s fiscal U-turn caught many investors unaware, triggering one of the most dramatic repricings of European bond markets since the depths of the eurozone crisis more than a decade ago.
Merz invoked memories of those tumultuous times when he declared he would do “whatever it takes” to bolster the country’s defence and infrastructure, echoing former European Central Bank chief Mario Draghi’s statement that helped end the continent’s sovereign debt crisis in 2012.
German bond yields jumped across the curve – alongside those in France, Italy and other European countries – as the 10-year yield ended Wednesday around 30bp higher at just below 2.80%.
"The €500bn of infrastructure spending and the fact that they announced almost no cap on defence spending took the market by surprise," said Camille de Courcel, head of developed markets rates strategy and economics for Europe at BNP Paribas.
BNPP estimates 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% over that time.
"We expect the market will remain volatile for some time because of the uncertainty over the disbursements [of Germany's planned spending increases] and because we don't know what will happen with US tariffs," de Courcel said.
Short-term pain
Traders say the sudden Bund selloff proved particularly painful for those betting on European bond yields staying low relative to other markets. That had become a popular trade in recent weeks amid concerns about the impact on eurozone growth if US president Donald Trump followed through on threats to impose sweeping trade tariffs on the European Union.
Many of those bets focused on shorter-dated bonds, which are more sensitive to moves in central bank interest rates, and traders on Wednesday reported some signs of forced selling of these positions.
Betting on a weaker euro had been another popular play in anticipation of a struggling eurozone economy. A dramatic rally in the single currency on Wednesday suggested many investors decided to dump those positions quickly when details emerged of Germany's fiscal plans.
"Everyone was punting on euro-dollar parity," said one foreign exchange market specialist, who said FX trading volumes had also risen steeply over the past couple of days.
The ECB cut interest rates on Thursday, as expected, but there is now considerable uncertainty over the trajectory of its monetary policy. Some economists said Germany’s spending plans could ease pressure on how far the central bank needs to cut rates over the longer term thanks to the projected shot in the arm to the local economy.
Tariff threat
The looming threat of Trump’s tariff plans continues to cloud the near-term outlook, however, with some economists signalling tariffs could more than offset the benefits of any increased spending by Germany.
“For now, we think [ECB] policy rates are likely to continue the descent in a cautious fashion, and believe the ECB is not done yet with cutting,” said Konstantin Veit, a portfolio manager at Pimco.
Either way, many expect the German bond selloff has further to run. Goldman Sachs strategists said 10-year yields could reach 3% in the near term, and potentially as high as 3.75% over a longer horizon as a result of a widening in Germany's fiscal deficit.
“While the final policy implementation may yet differ, the signal for higher Bund yields is clear,” the strategists said.
Additional reporting by Justin Knight