Financial Times: Germany’s increased defense spending threatens the Eurozone

Investors and experts have warned that Germany’s plan to increase defense spending could lead to higher government borrowing costs in the Eurozone and exacerbate financial pressures on other countries in the bloc, according to the Financial Times.

The British newspaper reported on Monday that the region’s largest economies are abandoning their historical tradition of avoiding borrowing, which previously led to German bonds being scarce and yielding negative returns, and are adopting a whatever it takes approach to financing military and infrastructure spending, which is having an impact on financial markets across the bloc.

German 10-year bond yields rose to nearly 3% this month for the first time since the global bond selloff in 2023.

This has increased government borrowing costs in other countries, given German debt’s role as a de facto benchmark for the bloc’s market, raising warnings about the implications of this rise for the finances of highly indebted countries.

“High yields could limit the financial capacity to increase defense spending outside Germany,” Soren Rad, head of European economic research at hedge fund Point72, told the Financial Times, particularly in France and Italy.

French 10-year bond yields rose to more than 3.6% this month, their highest level in more than a decade, surpassing levels reached during the height of its political crisis last year, and Italian bond yields also touched 4% for the first time since July.

A simulation by 72 Point, which takes into account rising defense spending and increased revenues, shows that without spending cuts in other areas or economic growth, Italy’s debt-to-GDP ratio could rise to 153% by 2030 and France’s to 122%, compared to around 140% and 115%, respectively, currently.

However, Rad explained that unstable paths can be avoided if countries cut spending or raise taxes, or if they benefit from a growth stimulus as an indirect result of increased German spending.

The Financial Times said that bond yield differentials, the additional costs countries pay for borrowing compared to Germany, have remained largely stable so far, indicating that markets aren’t yet concerned about the impact of higher borrowing costs on governments with more volatile financial situations than Berlin.

The Financial Times noted the euro’s rise, saying this reflects market optimism about the economic growth momentum that has contributed to higher yields, but some fund managers warn that these financial pressures could begin to emerge if other Eurozone economies follow Germany’s lead in borrowing to increase defense spending.

“I think spreads will also start to widen as pressures on the system increase… Countries that already have high debt-to-GDP ratios and high yields… will find it more difficult to borrow,” David Zahn, head of European fixed income at Franklin Templeton Asset Management, told the Financial Times.

This could widen the gap between borrowing costs across eurozone countries, with their financial positions coming under increased scrutiny, according to Zahn.

“Economic factors for individual countries will become more important,” said Conor Fitzgerald, portfolio manager at Wellington Management, a US asset manager, adding that there should be a general separation between borrowers.

Investors have been preparing for months for an increase in bond issuance.

German bond yields traded above European interest rate swaps for the same maturity for the first time in history, reflecting investor expectations of increased issuance volume, according to the Financial Times.

Some fund managers believe that while concerns about the expected volume of German bond issuance are growing, this does not necessarily mean a decline in demand for other countries’ debt.

“It’s not as if there’s a lack of funding for this (Germany’s additional spending),” Simon Dangoor, head of fixed income macroeconomic strategies at Goldman Sachs Asset Management, told the British newspaper.

“German households have significant savings that they can channel into financing this spending without undermining demand in other eurozone bond markets,” Dangoor explained, however, he added that there are other risks stemming from rising yields in general, as some countries could easily find themselves facing a debt sustainability crisis.

Investors also see increased liquidity in German bonds as a boost to eurozone policymakers’ efforts to position the euro as a reserve currency to compete with the dollar.

The Financial Times explained that one of the main obstacles to increasing euro reserves held by global central banks is the small size and disparity of the sovereign debt market compared to the broader market for US Treasury bonds, in addition to the scarcity of debt with the highest credit ratings.