Last night, the German government had its ‘whatever it takes’ moment. The planned €500bn infrastructure fund and defence exemptions will significantly add to bund issuance, and this fiscal sea change will permanently alter the way bunds trade.
Currently, a large chunk of the stock of bunds is still owned by the public sector. Foreign central banks own around 30% for reserve management purposes, while the euro system owns around 25% as a result of past QE policies. The private sector owns less than 50% of the stock outstanding. But demand for bunds is very high.
Despite markets willing to pay the German government, it would not budge and kept the supply of bunds constrained. But this clearly changed with the announcement last night. Bunds will likely start trading more like other safe haven bond markets in the future. This has important consequences for euro area sovereigns and global bond markets.
The bund is the bedrock of the euro area. It is the risk-free rate and the safe haven during market stress. Indeed, during fears of a euro area recession in 2019, even before pandemic-era QE, the demand for bunds was so strong that yields paradoxically dipped into negative territory. Much higher bund yields will raise the financing costs for all other sovereigns in the euro area significantly. Spreads to bunds of the most highly indebted economies, such as Italy, are already very tight.
It is unlikely they will become much lower from current levels. If the new long-term bond yield level for other large euro area countries now is 4-5%, this will have significant consequences for the debt sustainability of those countries. Indeed, with more bunds to buy, it is likely markets will put more pressure on these countries to reduce large debts, either via tax rises or government spending cuts.
Bund yields are also the anchor of global bond markets. Germany has by far the best fiscal fundamentals among large markets globally – not just in Europe. Although bunds will now become less scarce, Germany will continue to have the best fiscal fundamentals, even with the large debt expansion announced last night. Since many global bond yields trade relative to bunds, the German government’s action is equivalent to raising the global risk-free bond rate. Even US treasuries, historically the centre of all bond markets, may over time sell off significantly in response to higher bund yields.
By Tomasz Wieladek, chief European economist at T. Rowe Price
