Rates Spark: Finding room for increased defence spending

10Y Bund yields notched higher on Tuesday as bond markets weighed the prospect of rising debt issuance. Although joint European Union borrowing options are being contemplated, the EU Commission has also been mulling activating national escape clauses to its fiscal rules to allow for defence spending beyond the prescribed sovereign borrowing limits. Economy Commissioner Valdis Dombrovskis said a proposal would be presented in the “coming weeks” and indicated that the exceptions could remain in place for "several years".

Taking the 2024 spending levels as a starting point, the countries that have the most catching up to do to even reach NATO’s current 2% target level are the periphery countries Spain, Italy, Portugal, and Belgium. Even in countries that have met the 2% criteria, significantly higher defence spending appears to be in store – on top of any other investment backlogs that have been identified. Looking at Germany’s debt metrics, it is probably one of the few issuers with the fiscal room to stem additional funding needs. For a country like Italy, the EU forecasted last November that the debt-to-GDP ratio could approach 140% in the coming years.

For now, the tightening of eurozone sovereign spreads points to a market that is focusing more on the push towards additional joint borrowing, narrowing 10y Italian spreads over Bunds to their tightest since 2021. The prospect of higher Italian sovereign issuance seems to have taken a back seat amid hopes for the bloc moving ever closer together.

The front end of the EUR curve continues to look more anchored with markets still priced for the European Central Bank reaching 2% in the deposit facility rates by the end of the year. On Tuesday, the ECB’s Piero Cippolone made the point that the central bank's rate-setting would also have to take into account its shrinking balance sheet amid quantitative tightening – specifically also its impact on long-end yields which we would interpret as a clear nod to the swap spread developments e.g. in Bunds. In our money market outlook published yesterday, we also look at the implications for very front-end spreads.