Changing of the guard: Bonds react to European policy shifts

In a week that was a watershed moment for Germany with a substantial fiscal policy and defence announcement, we also saw a more subtle shift from monetary policymakers as the European Central Bank (ECB) adopted a more “evolutionary” approach.

Germany’s fiscal expansion

Overshadowing the ECB decision was Germany’s announcement earlier in the week that it would seek a big fiscal expansion and rise in defence expenditure. The CDU/CSU and SPD parties propose pushing through constitutional changes while the old German government is still holding office and it is more likely it can secure a necessary two-thirds majority in the German parliament. The timeframe is tight as the newly-elected parliament has to commence by 25 March at the latest. Briefly there were three key elements:

• Defence spending exceeding 1% of gross domestic product (GDP) would be exempt from the current restrictions of the constitutional debt brake (essentially allowing the government to raise an unlimited amount of debt to finance military spending).
• The constitutional debt brake would be amended to align federal states with the federal government so that they would be allowed to incur new annual debt of 0.35% of gross domestic product (GDP).
• A special fund for infrastructure would be created allowing €500 billion of spending spread over 10 years.

Rearmament should be good for the country’s Mittelstand (the small and medium-sized enterprises) that are the backbone of the Germany economy. With a strong record in engineering, Germany should be well positioned to capitalise on the additional domestic spending.

More welcome is the €500 billion fund for infrastructure (spread over 10 years) and necessary to get Green party support. This has the potential to benefit revenues more broadly and across more cyclical parts of the economy (manufacturing and construction). The accompanying rise in equity markets in Europe that has occurred recently is also helpful in terms of sentiment and the ease with which companies can raise capital, which could potentially lead to more favourable debt/equity structures. From a credit risk perspective, therefore, more government spending and the attendant multiplier effect should be supportive for corporate revenues and cash flows.

Easier said than done

But could markets be getting a little carried away? Back in 2022, following the outbreak of the Russia/Ukraine conflict, Germany set up a special defence fund of €100 billion (the Sondervermögen) to boost Germany’s military. Yet this is still far from exhausted and not set to be fully used up until 2027. To spend a large amount on defence, Germany will need to overhaul its procurement and red tape. To that end, the CDU and SPD have agreed to enact a separate bill to speed up the planning and procurement process.

Every action has a reaction

There is a not unreasonable concern that throwing money at something might simply lead to higher inflation, as companies increase prices quicker than they build productive capacity. It is telling that the share prices of defence companies have soared recently as analysts predict higher earnings.

Moreover, higher federal and state borrowing is likely to lead to competition for capital – pushing up bond yields, all else being equal. Deutsche Bank noted that the last time Germany embarked on a massive stimulus programme (German reunification in the 1990s), the extra spending was estimated to have pushed up Holston-Laubach Williams (HLW) estimates of r* (the natural rate of interest) by around 100 basis points (bp).¹ The proposed package is sizeable but smaller in relative scope but even so might be expected to push up German sovereign Bund yields by around half that amount.

Following the announcement of the German package, the 10-year Bund yield rose 30 bps to 2.79% on 5 March 2025, its biggest one day move of the last 30 years. In contrast, the yield on the ICE BofA Euro Corporate Index (Euro investment grade (IG) corporate bonds) rose only 20bp as credit spreads (the difference between the yield on a corporate bond and a government bond of similar maturity) absorbed some of the rise.

There are limits to how much of a cushion credit spreads can offer. At close of play on 5 March 2025, Euro Investment grade spreads were at 83bp, compared with a tight of 36bp over the last 20 years. Similarly, the spread on the ICE Euro High Yield Index was 274bp, which compares with a tight over the last 20 years of 178bp. Corporate fundamentals remain robust, which help justify current spread levels. There is room to tighten further but we need to be mindful that European investment grade spreads have only spent 13% of the last 20 years tighter than where they currently are and for high yield only 6%.²

On the other hand, duration on European corporate debt tends to be quite low given a prevalence in Europe for shorter corporate maturities (effective duration on Euro IG was 4.5 and on Euro HY was 2.7 at the end of February 2025.³ An effective duration figure of 2.7 means that a change in yields of 100bp is expected to change a bond’s price in the other direction by 2.7%. These relatively low durations should make any sensitivity to rises in yields more manageable, with the market adjusting fairly quickly.

We also need to recognise that many other factors affect corporate bond yields and spreads, from the individual conditions a borrowing company faces to investor appetite, so the fiscal background is just one dimension. A not unimportant factor is the monetary backdrop, which brings us to the latest ECB rate decision.

Known knowns and unknowns

Given all the excitement around defence spending of late, it feels fitting to quote Donald Rumsfeld, a former US defence secretary, and talk of known knowns. The 25 basis points (bp) interest rate cut by the European Central Bank (ECB) in March was not a surprise as it had been expected by markets. This brings the deposit rate down to 2.5%. The ECB sees inflation settling around its target rate of 2% over the next 2 years and averaging 2.3% in 2025. While recognising that monetary policy is becoming “meaningfully less restrictive”, the bank pointed out that the eurozone economy faces challenges, with economic growth projections marked down in response to lower exports, weak investment and uncertainty from trade policy.

It is easy to forget amid the flurry of excitement around the German fiscal package that economic growth in Germany and the eurozone has been moribund of late.

ECB President Lagarde stressed that monetary policy would reflect three key things:

• Assessment of the inflation outlook in light of incoming economic and financial data.
• Dynamics of underlying inflation.
• Strength of monetary policy transmission.

A notable omission was deliberate mention of fiscal policy, although Lagarde in the press conference was quick to point out that assessing the impact of potential fiscal developments in Germany and Brussels (where the European Union was also discussing additional defence spending) was a “work in progress”. It was seen as too early for the ECB to be in a position to determine what precisely it means for inflation and growth, not least because the policy changes still need to clear political hurdles and be implemented. There was widespread agreement, however, that additional spending would be a boost to European economic growth.

What was clear was that the ECB was determined to stress optionality. Lagarde refused to pre-commit to a particular rate path, insisting the central bank would follow a data dependent and meeting-by-meeting approach. Lagarde recognised that they have moved from a more static assessment where rate direction was clear (downward) to a more evolutionary one that recognises that 150 bp of rate cuts have already taken place, opening the possibility of a pause. Lagarde referred to a recent meeting of the G20 in South Africa where she had used a metaphor of the waters around the Cape of Good Hope where warm water from the Indian Ocean (rate cuts) are still mixing with the cold water of the Atlantic Ocean (remaining effects of earlier policy tightening).
For bond investors, we were left with known unknowns, as each ECB meeting comes into play.

Taken together, the first week of March has mixed outcomes for credit investors. On the one hand, we welcome a more assertive Germany and the additional fiscal spending, which should help corporates, but the downside is a potentially less predictable path for rates. In common with the ECB, we will be paying close attention to the upcoming macroeconomic and financial data.

¹Source: Deutsche Bank, Fixed Income Blog, 4 March 2025. Basis point (bp) equals 1/100 of a percentage point, 1bp = 0.01%.
²Source: Bloomberg, ICE BofA Euro Corporate Index, ICE BofA Euro High Yield Index, Govt OAS (option-adjusted spreads over governments), 5 March 2005 to 5 March 2025.
³Source: Bloomberg, ICE BofA Euro Corporate Index, ICE BofA Euro High Yield Index, effective duration, 28 February 2025.

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