Germany opens its wallet, and bonds tumble

German 10-year Bund yields jumped by roughly 30 basis points in a single day after Berlin announced a framework to reform its constitutional debt brake ('Schuldenbremse'). Decades of German fiscal restraint ended in one trading session. The government cited crumbling infrastructure, a shortfall in defence spending and years of industrial stagnation.

What Merz agreed

The plan was unveiled on the evening of March 4th by Friedrich Merz, whose Christian Democrats won last month's election, and the leaders of the Social Democrats, his likely coalition partners. It has three parts: defence spending above 1 per cent of GDP would be exempt from the debt brake, a special fund of €500 billion would pay for infrastructure over ten years, and Germany's states would be allowed to run small structural deficits of their own. The bond market's verdict came the next morning, when the rise in ten-year yields was the biggest one-day move since 1990.

The debt brake, written into the constitution in 2009, limits the federal structural deficit to 0.35 per cent of GDP. It was suspended during the pandemic, and in November 2023 the constitutional court struck down the government's attempt to move €60 billion of unused emergency borrowing into a climate fund. That ruling left a hole in the budget that the last coalition never filled, and the quarrel over how to fill it brought the government down last autumn. The €100 billion special fund created for the armed forces after Russia invaded Ukraine in 2022 is nearly spent.

Bunds lose their scarcity

For twenty years German government debt has been Europe's risk-free benchmark, priced richly because the constitution all but barred new borrowing. Loosening that rule to allow hundreds of billions of euros in special off-budget funds for defence and infrastructure removes the scarcity premium that Bunds carried. Primary dealers now expect a steady supply of new German bonds, and benchmark funding costs across Europe have moved up at once.

The mechanism runs from issuance to every other price in euros. Germany's debt, at a little over 60 per cent of GDP, is low by the standards of its peers, and banks, insurers and central banks have long competed for the limited stock of Bunds as collateral and safe assets. More supply means the marginal buyer demands a higher yield. Because Bunds anchor the pricing of mortgages, corporate bonds and Pfandbriefe across the continent, a German household fixing a home loan and a French company issuing a bond both pay more.

The euro moved the other way. Expectations of higher German growth and higher yields drew money into the currency, which rallied sharply against the dollar in the days after the announcement, and shares in German defence and construction companies surged. The European Central Bank, which cut its deposit rate to 2.5 per cent on March 6th, now faces a fiscal expansion in its largest member just as it considers how much further to ease.

The losers are the existing holders of long-dated German debt. Life insurers, pension funds and bank treasuries that had bought Bunds at lower yields took a mark-to-market loss in a single session, and the longest maturities, which are most sensitive to rate changes, suffered most. The gainers are fresh buyers and savers, who can now lock in higher returns than at any point in months. Exporters face a mixed bargain: a firmer euro makes their goods dearer abroad, while the prospect of heavy public orders at home promises some compensation in a domestic economy that shrank in both 2023 and 2024.

Italy's spread narrows

As German yields rose, the gap between Italian BTPs and Bunds narrowed sharply. A Germany willing to spend lifts demand across the euro area and suggests a readiness to pay for shared European priorities. Italy's debt is above 130 per cent of GDP, so any narrowing of its premium over Germany saves its treasury money every time it refinances. The European Commission's own plan, announced the same week, to mobilise up to €800 billion for defence, including loans raised at the EU level, adds to the sense that Europe's fiscal rules are being loosened together.

Reunification's precedent

The last time German borrowing jumped this abruptly was after reunification in 1990, and the comparison is instructive. Bonn financed the rebuilding of the east largely with debt, and the Bundesbank raised interest rates to contain the resulting inflation. Other European currencies were pegged to the Deutschmark, so they had to import Germany's tight money, and the strain broke the exchange-rate mechanism in 1992, when Britain and Italy were forced out. This time the policy mix is kinder. The ECB sets rates for the whole euro area and is cutting, not tightening, and there are no pegs left to break.

Where the call could fail

The plan is not yet law. Changing the constitution needs a two-thirds majority, and the parties intend to pass it through the outgoing Bundestag before the newly elected one convenes later this month, since the new parliament gives the far right and far left enough seats to block it. The Greens, whose votes are needed, have said they will not support the package in its current form. A failed vote would reverse much of the move in yields.

Even if it passes, the money may arrive slowly. German infrastructure projects are notorious for planning delays and lawsuits, the construction industry is short of workers, and the armed forces cannot absorb large procurement budgets overnight. If spending lags the headline figures, bond supply will grow more slowly than markets now assume and part of the jump in yields could fade. Watch the parliamentary vote, the next federal financing calendar and the first tenders for defence and rail contracts.

The direction, though, has changed for good. Berlin's turn from austerity to investment is unlikely to be reversed, so European borrowers should expect higher benchmark yields for years, while Italy and other peripheral issuers pay a smaller premium over Germany, and German households and companies will see the cost of fixed-rate borrowing rise before the first new bridge or tank is paid for.