Fear of German Debt Binge Flips Key Market Gauge for First Time

(Bloomberg) -- Traders braced for the possibility of more bond sales in Germany after a government figurehead for fiscal conservatives was sacked, leading some in the market to contemplate a new administration that could be more tolerant of higher debt.

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A widely-watched gauge of angst about bond supply rose, with the German 10-year yield climbing above the equivalent swap rate for the first time on record. In another sign of growing fiscal concerns, the 30-year yield jumped more than the two-year, lifting the spread toward the highest in more than two years.

Chancellor Olaf Scholz opened the door to snap elections Wednesday when he fired Finance Minister Christian Lindner, who is opposed to relaxing rules that severely constrain government borrowing. Lindner is known for being a strong proponent of domestic fiscal discipline and has kept a tight leash on spending since he took office in 2021.

“The way toward more debt will most likely become easier without a finance minister Lindner,” Commerzbank AG strategist Hauke Siemssen wrote in a note.

That helped fuel the selloff in debt, despite opinion polls suggesting fiscal conservatism might remain under a new government. The center-right alliance under opposition leader Friedrich Merz is seen leading; its stances include fierce opposition to additional joint European Union debt and supporting strict rules on new borrowing.

The difference between bond yields and swap rates — the swap spread — is an important gauge of future issuance because bonds tend to weaken relative to swaps as the market anticipates more sales.

Historically, the spread has been positive because governments bonds are safer than swaps, where the counterpart is typically a financial institution. But that relationship was upended Thursday, the latest leg of a long-term trend that has picked up pace across the world. The moves reflect investor fears over higher debt supply at a time when central banks are also reducing their holdings, increasing the amount markets have to digest.

What Bloomberg economists say...

The breakdown of the coalition probably means the 2025 budget is harder to agree. A likely dependence on fiscal hawks to form a new coalition means there is a low probability of significantly wider deficits to finance much-needed investment. It may take a deeper crisis for that to happen.

— Martin Ademmer, an economist for Bloomberg Economics. Read his full note here.

Focus on government debt piles has sharpened this year, with the UK, France and the US all in the cross-hairs. Only yesterday, US Treasuries sold off sharply in a sign of investor misgivings about Donald Trump’s fiscal policies after he won the presidential election. Meanwhile, France’s borrowing costs have surged relative to peers given its large deficit.

To be sure, Germany has long been the poster-child for fiscal discipline across the region. Its current debt pile relative to economic output is more modest than many of its neighbors, meaning it has more capacity to issue more debt before stirring the so-called bond vigilantes. Its debt-to-GDP ratio is around 63%, compared to 112% in France.

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And Thursday’s slump in German bonds may give way to gains if a new government shares Lindner’s opposition to higher debt.

“Looking at polls, right-wing parties (fiscal hawks) are gaining popularity,” said Evelyne Gomez-Liechti, multi-asset strategist at Mizuho International. “If Germany goes back to strict fiscal policy, that may be a strong catalyst for ongoing economic weakness, bunds rallying and swap spread widening.”

German bonds clawed back most of their losses as investors adjusted positions ahead of the Federal Reserve’s interest-rate decision due later Thursday. Borrowing costs on 10-year notes were two basis points higher at 2.42% as of 4:15 p.m. in London after earlier surging to 2.5%.

Still, German debt sales next year are already forecast to be a record. Citigroup Inc. strategist Puja Sawant expects net bond issuance will climb to €139 billion ($149.5 billion), a number exceeded only by France in the euro-area. The figure also reflects debt that will roll off the European Central Bank’s portfolio as it continues to shrink its holdings.

Scholz has argued Germany needs “more financial wiggle room” to deal with its challenges. Once Europe’s economic powerhouse, the country is now grappling with a lengthy retreat in its manufacturing sector, which faces higher energy costs and competition from markets including China. Trump’s threat to impose new tariffs are likely to add to the headwinds.

(Adds German yield changes in the 12th paragraph.)

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