(Bloomberg) — The selloff in Germany’s bonds spilled over to a second week as Chancellor-elect Friedrich Merz won crucial political backing for a debt-funded spending package to boost defense and infrastructure.
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Longer-dated bonds took the brunt of the weakness, with the 10-year yield rising as much as eight basis points on Friday to 2.94%. It’s now within touching distance of the 3% milestone last breached in 2023.
Merz told reporters in Berlin on Friday afternoon that he reached an agreement on the spending package with the Green party, which had rejected the initial plan and demanded a greater commitment to climate protection. The deal is a breakthrough for Merz, and overcomes a key hurdle ahead of a crunch vote in parliament next week.
“If this goes through, it will change the perception of Germany. For ages, it’s been the country that has been reluctant to increase debt,” said Ugo Lancioni, fund manager at Neuberger Berman. “Spending will probably occur over several years and the positive growth impact in Germany and Europe related to recent measures will likely be felt from 2026.”
Lancioni said European yields are attractive and encourage adding exposure gradually. German rates spiked on reports about the deal but pared the advance when Merz confirmed the agreement, suggesting the current level of yields may be starting to entice some buyers.
Germany’s 10-year yield is up more than 50 basis points this month as investors adjusted to the perspective of more borrowing from Europe’s largest economy. That drove the gap between two- and 10-year rates to 70 basis points, the steepest since mid-2022.
The moves spread to the rest of the region, driving France’s long-term borrowing costs to the highest level since 2011. A Bank of America’s sentiment survey published earlier Friday showed investors turned underweight on core euro-area fixed income for the first time since 2023.
“Core Europe duration longs collapsed as future economic growth and bond supply get priced in,” BofA strategist Ralf Preusser and colleagues wrote in a note earlier.
What Bloomberg Strategists Say…
The agreement in Germany for a potentially huge debt package is predictably pushing German and other European bond yields higher. However, the asset swap’s fall has been modest this year, indicating there is no significant marking down of German credit risk.
— Simon White, Bloomberg Macro Strategist. Read more on MLIV.
The euro, in the meantime, got another boost as hopes of more spending and growth are seen limiting the room for further interest-rate cuts from the European Central Bank. The currency rose as much as 0.6% to $1.0912, taking its advance this month to 5%, one of the best among major currencies.
“Game on again for the euro,” said Brad Bechtel, head of FX at Jefferies, adding that peace talks for Ukraine are adding to the currency’s momentum.
Less than three weeks since winning the Feb. 23 election, Merz and the SPD are racing to approve the debt-financing package in the current parliament before the new Bundestag convenes on March 25. That includes sweeping measures that would release defense spending from debt restrictions and set up a €500 billion ($542 billion) fund for infrastructure investment.
Constitutional changes in the newly formed assembly face a higher threshold, since a surge in support for the far-right Alternative for Germany and anti-capitalist Left mean that they hold an effective block on a two-thirds majority.
The agreement on Friday also lift European stocks, with German shares outperforming.
Transatlantic Gap
The German bond rout came just as Treasuries rallied on growing US economic concerns, causing the spread between yields across the Atlantic to narrow sharply.
The difference between 10-year US and German rates tightened almost 40 basis points this month to 140 basis points. Societe Generale SA strategists including Jorge Garayo see it collapsing to just half a percentage point by year-end, a level not seen since 2013.
The forecast highlights the generational shifts at play in bond markets as Merz leads Europe toward an era of higher spending. The region’s leaders have been left scrambling to modernize defense systems and infrastructure as the decades-old Transatlantic alliance starts to buckle under US President Donald Trump’s America First policies.
The yield gap was as big as 230 basis points just three months ago, when expectations of higher-for-longer interest rates in the US were at their peak and drove a selloff in Treasuries. At the same time, the prospect of deep cuts from the ECB to support the bloc’s stuttering economy were capping local bond yields.
Now, Germany’s shock-and-awe debt package can push the 10-year yield to 3.2% by year-end, according to Societe Generale. They see the US 10-year yield sliding from 4.3% now to about 3.75% as the impact of Trump’s start-stop trade tariffs erodes investor confidence and hampers the economy.
–With assistance from James Hirai.
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