We often encounter the phrase “a week is a long time in politics”, highlighting the volatility and unpredictability of politics as unexpected events can lead to dramatic changes in political landscapes in a very short period of time. This phrase is also very apt for capital markets, and last week was testimony to various unforeseen developments leading to unexpected movements across most asset classes in several parts of the world.
During the fourth quarter of last year and in early 2025, the consensus view among most financial analysts was that the US stock market (driven by continued AI investment and boosted by Donald Trump’s promised tax cuts and deregulation) will continue to outperform European markets in view of the eurozone’s very weak economic performance, while the US dollar will continue to strengthen to a level of well below parity against the single currency.
But the victory of the centre-right CDU/CSU in Germany’s election at the end of February and the famous meeting at the Oval Office with Ukraine’s president led to far-reaching announcements and fiscal manoeuvres, creating a period of upheaval that some market commentators are comparing to the onset of the pandemic or the global financial crisis.
The incoming German Chancellor Friedrich Merz announced last week that the probable coalition of conservatives and Social Democrats had agreed a €500 billion investment fund to revive the country’s stagnant economy. Merz also noted that defence spending above 1% of GDP would be excluded from the country’s “tough debt rule” that came into effect in 2009 when Chancellor Angela Merkel had responded to calls for a German economic rebalancing by establishing a constitutional debt brake that put a strict limit on budget deficits.
Merz’s announcement was labelled as a historic German economic policy U-turn. The radical shift in Germany’s fiscal policy stance will lead to a significant rise in public spending and government debt that will finance unprecedented investments in the defence and infrastructure sectors. This major development is bound to reshape economic policies in Europe’s largest economy in the years ahead. Germany has ample room to increase its public spending since its public debt-to-GDP ratio of 63% is low compared to other major economies. But it has already been stated that the ratio might exceed 100% by 2034 as a result of the fiscal policy U-turn.
Separately, European Commission President Ursula von der Leyen unveiled an EU plan for increased public spending. The plan’s main parts include (i) a ‘Rearm Europe’ plan that will allow member states to increase their defence spendings without triggering the Excessive Deficit Procedure of the existing fiscal framework; (ii) an EU loan facility of €150 billion to help member states finance their defence investments; (iii) reviewing the EU budget to direct more funds towards defence-related investments, and (iv) facilitating and mobilising private capital financing for future European investment needs.
These announcements triggered an incredible rally in the German DAX index to fresh all-time highs as well as the sharpest daily rise in the 10-year Bund yield since Germany’s unification in 1990. Meanwhile, the bloc’s single currency jumped to USD1.09 (its highest in over two years) and is no longer forecast to drop below parity against the US dollar.
The yield on the benchmark 10-year German government bond rose by over 30 basis points on March 5 to 2.79% and also surpassed 2.90% by the end of last week. The German bond yields spike reflects higher issuance of government debt in the coming years and an improved economic growth outlook as a result of the planned fiscal stimulus.
German government bonds, or bunds, are widely regarded as a ‘safe haven’ during market stress. Their rate of return, or yield, is considered as the risk-free rate of the euro area and influences yields on sovereign bonds of other countries. Last week’s surge in yields essentially leads to an increase in borrowing costs for all other governments in the euro area. This was also evident in Malta as the secondary market yields quoted by the Central Bank of Malta for Malta Government Stocks (MGSs) also rose markedly.
This is evident in the latest MGS maturing in 10 years’ time, the 3.5% MGS 2035, that was issued at a price of €100.50 last month. The indicative bid price quoted by the Central Bank of Malta dropped from €101.50 at the end of February to €98.67, representing a decline of 283 basis points as its yield increased by 32 basis points from 3.33% to 3.65%.
The sharp upturn in eurozone yields took place despite the European Central Bank announcing a further cut in interest rates, the sixth in nine months. As expected, last Thursday, the ECB reduced interest rates by 25 basis points, with the deposit rate down to 2.50% from a high of 4% in June 2024.
Following the success in lowering the level of inflation which had surged in early 2022 and 2023, the ECB has consistently reduced interest rates since June 2024. On Thursday, the ECB signalled further potential easing of its interest rate in the future despite revised inflation projections that show that the inflation rate will rise to 2.3% this year but to then drop to 1.9% by 2026.
But the ECB also noted that “monetary policy is becoming meaningfully less restrictive”, confirming that the rate-cutting cycle may soon end. In fact, the consensus view is that the ECB will proceed with two additional rate cuts by the end of 2025.
On the other hand, at last week’s press conference, ECB President Christine Lagarde said the recent developments in German and EU fiscal policy and defence spending have not yet been included in the ECB’s forecast. Lagarde indicated that defence and infrastructure spending “could be inflationary” and “could add to growth”, which would, in effect, reduce prospects of more ECB policy easing and actually force the bank to end its rate cut cycle earlier than expected.
The impact of this radical change in fiscal policy will only be felt in the medium term. While the full implications are currently still difficult to fully assess, this is likely to be a game changer for the dynamics of Europe and for all asset classes.
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