Germany’s fiscal shift and the bund: when security comes at a price
We analyse how the agreement to reform the constitutional debt ceiling and boost defence spending will impact German sovereign debt and the yield on the 10-year bund.
Germany has shifted gears in its public spending policy. At the beginning of March, the leaders of the CDU/CSU, the SPD and the Greens presented a proposed agreement to reform the constitutional debt ceiling and significantly boost military and infrastructure spending, and on 21 March the agreement was ratified by the legislative chambers. The total spending approved for the next decade will finally amount to over one trillion euros.1 In this article, we analyse the impact of this new policy on German sovereign debt and, in particular, on the yield of its 10-year benchmark (known as the bund, being the federal bond, which is considered the euro area’s main risk-free asset) as well as its future outlook.
- 1. On the one hand, there is a specific fund of 500 billion euros for infrastructure, to be implemented over the next 12 years, which will mean around 42 billion euros per year on average (1% of 2024 GDP). In addition, 100 billion euros will be allocated to environmental and energy transformation policies, and the federal states will be allowed to invest more, which could amount to another 15 billion euros per year (0.35% of GDP). On the other hand, defence spending exceeding 1% of GDP will be exempted from the constitutional debt limit.
The market reaction to these announcements was significant and, in the week in which the pre-agreement was reached, the yield on the bund rose 50 bps. Let us begin by analysing this movement relative to that of other financial assets. The first thing to note is that the yield on German debt had already priced in a likely future increase in public spending. The spread of the bund relative to an interest rate highly dependent on the ECB’s intervention rate (which can be interpreted as a German risk premium) had already widened significantly since the end of last summer, when doubts began to arise about the stability of the previous German government and the country’s economic expectations deteriorated (43 bps between 10 September and 5 March, see first chart).2
- 2. Risk premium measured as the spread between the yield on the bund and that of the 6-month Euribor swap rate.
This expansion is also apparent in some valuation models for the bund. For example, in a model which takes into account medium-term expectations for euro area interest rates and general conditions for risk, liquidity and the supply of public debt, we see a clear upward trend since the summer in the yield on German debt, distancing it from what would be expected based on its historical relationship with these variables (see second chart). Between the end of last year and the week prior to the announcement, the spread of the bund relative to the theoretical value indicated by this model stood at around 30 bps (or a standard deviation), probably because investors were already anticipating higher public spending in Germany.
In the week in which the agreement was finalised, the price of the bund rebounded, as mentioned, by 50 bps, while its theoretical value according to this model was up 30 bps. We can thus interpret that 30 bps of the upturn in the bund was due to the change in monetary policy expectations, while the other 20 bps (which correspond to the widening of the spread between the theoretical and observed values) correspond to the fact that the fiscal boost was greater than that already priced in by the market. Following the announcement, the bund seems to have stood those 50 bps above its theoretical value, and this gap has persisted with the market movements triggered by Trump’s tariffs.
This difference between the actual yield on the bund and that suggested by other market variables allows us to reflect on two possible future scenarios. In the first, based on the assumption that the historical relationship with other instruments has not changed, one of the two assessments – either the observed one or the predicted one – would converge with the other. In other words, either the German spending programme will manage to revive the country’s economy and exert a pull effect on the rest of the euro area, in which case we should see an increase in interest rate expectations, or alternatively the programme is unsuccessful and we would see a drop in the yield on the bund from its current levels.
In the second scenario, the historical relationship would have been altered and with the change in gear in its public spending policy the spread between the yield on the bund and that of other low-risk assets would now be structurally greater. This scenario seems likely, primarily because on the supply side the change in public spending policy does not appear to be cyclical. On the demand side, and even if this were already the case prior to the German spending announcement, the increased volume of German debt issues is coming at a time when the ECB is no longer making reinvestments under its asset purchase programmes, so from now on the demand it previously provided will have to be substituted by other market players. That said, the increase in public debt is expected across the euro area, and possibly in all developed markets. This could therefore result in Germany maintaining its status – relatively speaking,
of course – as an economy with limited debt, which will nevertheless pay slightly more to place that debt in the market.
Another way to analyse both the movement of the bund and its likely future performance would be to look at the impact of macroeconomic variables on the price of the debt. From this perspective, what the historical relationships reveal is that, as we would expect, policy rates (i.e. the rates set by the ECB) are the main determining factors for the yield on the bund. Inflation also has a significant impact on the yield, although it is somewhat variable, since it depends on how concerned investors are about prices at any given time.
As for GDP growth in Germany, it does not seem to have any influence beyond that detected through the impact which growth has on ECB interest rates. Moreover, economic growth acts through other channels, such as determining the debt/GDP ratio. More indirectly, how effective the spending is in stimulating the German economy and its long-term growth will influence where long-term interest rates lie.
The level of public debt, on the other hand, does have a more stable and constant impact on the yield on the bund over time. However, as already mentioned, just as important as Germany’s debt-to-GDP ratio is that of the rest of the euro area. Any widespread increase in this ratio across the euro area, as occurred during the COVID-19 pandemic, does not create additional pressure exclusively on the bund, as it allows Germany to continue to have a low level of debt relative to other countries.
While the definition and implementation of the fiscal stimulus is being finalised, both in Germany and in the rest of the euro area, we estimate that a gradual increase in the debt-to-GDP ratio, consistent with the expectations of a gradual implementation of the stimulus, would cause the yield on the bund to be around 30 bps higher compared to a situation without any stimulus (see third chart). This level reflects both slightly higher inflationary pressures in Germany and the country’s growing funding needs,3 in a context in which the impact of the ECB’s balance sheet reduction programme (quantitative tightening) on the price of public debt is still limited, given that liquidity remains high and there is an appetite for this class of asset among investors.
- 3. In a scenario with a gradual implementation of the stimulus, the country’s additional funding needs would represent approximately 0.3 pps of GDP in 2025, 0.8 pps in 2026 and around 0.9 pps in 2027. We estimate a moderate impact on GDP and a very mild impact on inflation. The debt-to-GDP ratio would only increase by 3 pps by 2027 relative to its 2024 levels. The depo rate would behave as currently predicted by money market implied rates.
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