Eurozone bond yields jump

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 the 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 the continued AI investment theme and boosted by the promised tax cuts and deregulation of the new US President Donald Trump) will continue to outperform the European markets in view of the very weak economic performance across the eurozone while the US dollar will continue to strengthen to a level of well-below parity against the single currency.

However, Germany’s election results at the end of February with the centre-right CDU/CSU winning the election (becoming the largest party in the next Bundestag and with Friedrich Merz as the incoming Chancellor) together with the outcome of the famous meeting at the Oval office with the President of Ukraine, 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 that the probable coalition of conservatives and Social Democrats had agreed on a €500 billion investment fund to revive the country’s stagnant economy. Mr Merz also noted that defence spending above 1% of GDP would be excluded from the country’s “tough debt rule” which came into effect in 2009 as the then Chancellor Angela Merkel responded to calls for a German economic rebalancing by establishing a constitutional debt brake that put a strict limit on budget deficits.

Last week’s announcement by the incoming German Chancellor has been labelled as a historic German economic policy U-turn. The radical shift in Germany’s fiscal policy stance will lead to a significant increase in public spending and government debt which 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 seen to be low compared to the other major economies across the world. However, it has already been stated that Germany’s debt to GDP ratio might exceed the 100% level by 2034 as a result of the fiscal policy U-turn.

Separately, the European Union also unveiled a plan for increased public spending. The main parts of the plan presented by European Commission Ms Ursula von der Leyen 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 EUR150 billion to support Member States in financing 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 more than two years) and is no longer forecast to drop below parity against the US Dollar.

The yield on the benchmark ten-year German government bond increased by over 30 basis points on 5 March to 2.79% and also surpassed the 2.90% level by the end of last week. The spike in German bond yields 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. The surge in yields last week 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 the existing Malta Government Stocks (MGS) in issue also rose markedly higher.

This can be 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 announcement by the European Central Bank (ECB) of a further cut in interest rates (the sixth time) 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 bringing down the level of inflation which had surged in early 2022 and 2023, the ECB has been consistently reducing interest rates since June 2024. On Thursday, the ECB signalled further potential easing of its interest rate in the future despite revised inflation projections which show that the inflation rate will rise to 2.3% this year but to then drop to 1.9% by 2026.

However, 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, during last week’s press conference, the President of the ECB stated that the most recent developments in German and EU fiscal policy and defence spending have not yet been included in the ECB’s forecast. President Ms Christine 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 over 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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