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Investors are betting on reform of the “debt brake” enshrined in Germany’s constitution as markets brace for an increase in borrowing by Berlin.
A sell-off in Germany’s 10-year debt in recent weeks has seen its yield trade above the rate for euro interest rate swaps of the same duration for the first time, a key market indicator that is sensitive to expectations of future bond issuance.
The move ahead of federal elections in February signals investors’ belief that “a snap election means debt brake reform”, according to Tomasz Wieladek, chief European economist at asset manager T Rowe Price. “That in turn would mean more issuance.”
So-called “swap spreads” have long been positive in Germany — unlike in other major bond markets where they have often traded below zero — meaning investors have been willing to accept a lower return to hold Berlin’s debt relative to expectations of long-term interest rates.
This unusual feature of Germany’s bond market has been a function of the relative scarcity of Bunds, which serve as the benchmark risk-free asset for the entire euro area and have often been in short supply due to the country’s reluctance to borrow heavily.
The debt brake caps new borrowing by the federal government at 0.35 per cent of GDP, adjusted for the economic cycle, and also bars Germany’s 16 individual states from taking on any new debt at all.
It was written into the German constitution in 2009 and took effect in 2016, though it was suspended during the Covid-19 pandemic and again after Russia’s full-scale invasion of Ukraine, before being reinstated this year.
But economists have often criticised the rule as being too inflexible.
And it has become a bone of contention between the left and right in German politics, the former arguing it should be reformed to allow major investments in areas such as infrastructure and the latter insisting it must be maintained to protect future generations against a huge debt burden.
The debt rule was one of the main reasons why Chancellor Olaf Scholz’s three-party coalition fell apart earlier this month.
Scholz, a social democrat, demanded his finance minister Christian Lindner, leader of the fiscally hawkish FDP party, suspend the debt brake to allow for more aid to Ukraine. Lindner refused, so Scholz sacked him. The FDP then quit the government.
Scholz, who has now lost his parliamentary majority, will table a confidence vote on December 16, paving the way for early elections on February 23 which the opposition Christian Democratic Union is widely expected to win.
The CDU’s leader, Friedrich Merz, had long considered the debt brake sacrosanct. However, last week he said for the first time that it could be reformed.
Speaking to a business conference last Wednesday, he said only a few articles of the constitution were immutable. “Everything else can be debated,” he said.
The decisive question, he added, was what the new borrowing was used for. “Is the result that we spend more money on consumption and welfare? Then the answer is no,” he said. “Is it important for investments, is it important for progress, is it important for our children’s’ livelihood, then the answer can be different.”
Rohan Khanna, head of European rates research at Barclays, said the switch-around in yields and swaps was the culmination of a broader shift in Germany’s economy from one of high growth and low borrowing, to low growth and higher borrowing, making it more like other Eurozone markets.
It is a “reflection of the fact that the German bond market broadly and the economy ideologically have lost their specialness,” he said.