Germany's Historic Debt Surge: Record Bond Yields and Fiscal Expansion

Germany's Historic Debt Surge: Record Bond Yields and Fiscal Expansion 

The surge in German bond yields today is being attributed by some to optimism, but the extent to which the increased defense spending will contribute to federal growth remains uncertain. One thing, however, is clear: Germany's deficit and debt levels are set to increase substantially. A key measure of the attractiveness of German debt has reached its lowest point ever, following the government's announcement of a historic fiscal package designed ostensibly for defense spending, but which critics see as an excuse to inject significant amounts of debt into the economy, using the Ukraine situation as a catalyst. This fiscal maneuver has caused the German 10-year bond yield to exceed its swap rate by 12 basis points, a record high going back to 2007.

The swap spread, the difference between bond yields and swap rates, is an important indicator of future bond issuance. As the market anticipates more bond sales, the yields tend to fall relative to swaps. As highlighted by Goldman Sachs' Alberto Bacis, Europe is leveraging heavily, engaging in a massive leveraging exercise. Rising sovereign bond yields are the last thing one would want in such a situation, and this is precisely what is happening now. The Bund yield has spiked by 30 basis points today, the largest increase since 1990.

If bond yields continue to rise, three scenarios may unfold. The first possibility is that a sovereign nation, facing the escalating cost of re-leveraging, finds the situation unaffordable. This could lead to a significant sell-off in bonds, pushing yields to levels that become problematic, and triggering a "bond vigilantes" type of market response that could impact countries with limited fiscal flexibility and poor credit ratings, especially before the EU rearmament plan comes into effect. This scenario would not be positive for the euro, as buying the euro when sovereign yields are rising sharply may not prove effective.

The second possibility is that Germany steps in to use its financial resources to support all of Europe, guaranteeing the liabilities of other nations. The third scenario is that markets stabilize and the extreme moves seen today are partially unwound. Regardless of which scenario prevails, what is happening now is effectively putting a limit on the leveraging process. The German government has announced hundreds of billions in new expenditures, but leverage only works when the cost of financing is manageable. There are limits where the cost of funding becomes prohibitive, and if this continues, the figures announced yesterday may need to be reduced by 25% to account for the higher borrowing costs.

The announcement by Germany's leaders last night marked one of the most significant fiscal shifts in the country's post-war history. The leaders of the CDU/CSU and SPD parties revealed a plan that was even more expansive than anticipated earlier in the week. The proposal involves three major changes to Germany's debt restrictions. First, a special-purpose off-budget vehicle worth EUR 500 billion (about 11.6% of GDP in 2024) will be created to fund infrastructure investments over the next decade. This will amount to about 1% of GDP in annual infrastructure spending, with EUR 100 billion allocated to federal states. Second, the debt brake will be reformed to exclude defense spending exceeding 1% of GDP from the main budget. Currently, defense spending amounts to EUR 53.25 billion, or 1.25% of nominal GDP, and this change would allow for unlimited borrowing for defense. Third, the proposal includes increasing the allowable structural deficit for states from 0% of GDP to 0.35%, bringing it in line with the federal level. Additionally, an expert commission will be formed to develop a long-term reform plan for the debt brake by the end of 2025, which must be passed by the newly elected Bundestag.

All of these changes will require a two-thirds supermajority in the Bundestag. The parties aim to pass these measures with the outgoing 20th Bundestag before the newly elected parliament convenes on March 25. Leaders from the centrist parties have referred to this decision as a "whatever it takes" moment, demonstrating their determination to fully rearm Germany. This rhetoric suggests that the unlimited borrowing for defense could be used rapidly, potentially bringing German defense spending to at least 3% of GDP as soon as next year, although the exact target may be defined after the NATO summit in June.

If these measures are implemented, Deutsche Bank's Jim Reid warns that everything previously known about Germany's economic outlook must be reconsidered. A look at Germany's fiscal deficit over time, incorporating an additional 3% deficit over the next decade, puts this shift in perspective. If growth rebounds, it could reduce the deficit, but this fiscal stimulus could be unprecedented in Germany's history. Germany is still expected to maintain the lowest debt-to-GDP ratio in the G7 for the foreseeable future.

It is estimated that Germany could spend around $1.6 trillion before its debt-to-GDP ratio reaches that of the second-lowest in the G7, the United States. Over time, this package could amount to roughly $1 trillion, with the US likely increasing its debt during this period as well. In a more extreme scenario, Germany could potentially spend $8.5 trillion before its debt-to-GDP ratio reaches that of Japan's. The significance of this fiscal move cannot be overstated, as it will have lasting implications for investment portfolios over time.

The bond market has already reacted dramatically, with German bond yields surging by over 24 basis points, the largest single-day increase in history. Despite concerns about the sustainability of Germany's debt, which is currently only about 63% of GDP—far lower than other major Western economies like France, the UK, and the US—investors are betting on Germany's growth trajectory, driving risky assets like stocks higher and leaving ultra-safe government debt behind.

Some analysts attribute the rise in yields to the perception that Germany is preparing to stimulate growth, which is seen as a positive for risk assets. However, there are doubts about the sustainability of this optimism, especially as swap spreads continue to widen. Europe is known for facing sovereign debt crises at the most inopportune times, and if inflation remains persistent, the yield on new German debt could become unsustainable, prompting the European Central Bank (ECB) to intervene and monetize Germany's deficit spending, as it did during much of the past decade. However, such an intervention would likely require a market or deflationary shock to trigger it, and given recent events, it is likely the ECB would find another crisis to exploit.

This surge in borrowing comes after Ukrainian President Zelensky publicly rejected a deal with former President Trump in the Oval Office, prompting US Vice President Vance to suggest that European allies may have played a role in this decision, possibly to set the stage for a new crisis. This scenario could allow Germany to bypass its debt restrictions under the guise of ensuring security, freedom, and democracy. As Germany's government change approaches on March 24 and the far-right AfD party gains influence, the ability to block this massive debt plan becomes more significant.

In the end, the sudden acceleration of debt and defense spending in Germany raises many questions about the future of Europe's economic and fiscal stability. As the situation develops, the full ramifications for markets and Germany's debt trajectory will continue to unfold, with far-reaching consequences.