Rates Spark: Markets cautious in anticipation of German spending

The market reaction to the German election outcome was relatively modest. 10y Bund yields tracked towards 2.5%, underperforming modestly versus swaps. In part, this could just be an unwind of the moves on Friday, but overall it also suggests that markets are not ready to dismiss prospects of significantly higher debt issuance ahead.

The election outcome points to a grand CDU/CSU and SPD coalition. But with regards to a possible reform of the debt brake, the more centrist parties CDU/CSU and SPD, along with the Greens, do not hold the necessary two-thirds majority – any reform would also require votes from the Left. The Left has indicated its openness for reform with a view to infrastructure spending but is likely to oppose any changes to support a significant increase in military spending. The AfD has already opposed any change to the debt brake. The future government could also decide to declare an emergency situation around Ukraine to suspend the debt brake temporarily, but it is questionable whether financing a longer-term reoriented defence strategy would pass the constitutional test.

However, the Greens proposed on Monday to reconvene the current parliament to reform the debt brake or decide on special funds to finance the military – the newly elected parliament convenes only on 25 March. The CDU’s Merz has signalled a willingness to engage in talks and a figure of up to €200bn for a special fund has been cited by Bloomberg. Markets will not dismiss the possibility that geopolitical developments and changing realities can still push decision-makers down this route.

Common EU issuance to finance military spending is of course also an ongoing discussion, but something that the CDU has been sceptical of as well. Europe is seen moving closer together in light of the rising security threats, but we would argue that at least compared to the outgoing government, such a path has become less straightforward. The FT reported that the UK and EU finance ministers will hold talks at the upcoming G20 meeting this week, with the Polish minister indicating "it could be a fund or a bank".

As such we do have the feeling that markets are too optimistic about the timelines and political/practical hurdles and see the possibility that financing via national debt looks more likely near term which would call tight European Government Bond valuations, especially versus Bunds, into question.