German bond market shake up as defence spending breaks debt brake

European government bond markets experienced renewed turbulence yesterday as Germany announced a €500 billion investment fund while loosening its strict fiscal borrowing rules. The yield on Germany’s benchmark ten-year government bond, known as the “bund,” surged by as much as 13 basis points to 2.93 per cent. This followed a steep 31 basis points rise the previous day—its largest one-day movement since 1997—before recovering some ground later in the day.

The German government’s decision to ramp up borrowing aims to invigorate its stagnant economy, with plans to channel funds into defence and infrastructure projects. Yields on French and UK government bonds also spiked, reflecting a widespread investor reaction. France’s ten-year bond yield climbed 13 basis points to 3.63 per cent, while UK gilt yields rose by 8 basis points to 4.78 per cent. Yields, which rise as bond prices fall, marked a second consecutive day of heavy selling in global bond markets.

The incoming German Chancellor, Friedrich Merz, announced that defence spending exceeding 1 per cent of GDP would no longer be limited by the nation’s “debt brake” rule. This strategic fiscal move has been linked to shifting global geopolitical dynamics, especially following signals from the United States that it intends to scale back military support for Europe under the current administration. The possibility of decreased US involvement has led economists to predict faster German GDP growth in the year ahead, reversing contractions seen in 2023 and 2024.

With a notable shift in fiscal conservatism, Germany is setting the stage for what experts consider a seismic departure from its long-held financial policies. According to Jim Reid, Deutsche Bank’s global head of macro, the scale of this policy reversal is still yet to be fully comprehended by the global investment community, though market reactions suggest fast-money and agile investors have begun recalibrating their positions.

European equity markets exhibited sharp gains despite the bond sell-off. Germany’s DAX index climbed by 1.5 per cent, closing at a record high for the second day in a row, while France’s CAC 40 index rose by 0.5 per cent. However, the UK FTSE 100 slipped by 0.8 per cent, marking its third consecutive day of losses. Amid these fluctuations, the pound remained flat against the dollar at $1.289 but weakened by 0.31 per cent against the euro, falling to €1.191.

The broader implications of Germany’s unprecedented fiscal policy could reshape European financial markets and global investor sentiment, as heightened borrowing and infrastructural spending bolsters investor confidence in growth prospects across the region.