The market reaction to European military defence plans has been enormous, with more volatility expected in bond yields, curves, cross-market spreads and currencies
“May you live in interesting times”
Geopolitical shockwaves have arrived at surprising speed in recent weeks. The consequence of US president Donald Trump’s decision to halt financial and military support for Ukraine, coupled with a warning that the burden of providing a military shield for Europe would cease to be a job for the US, has marked an inflection point and triggered a bold response from Europe.
The proposed plan also includes a €500 billion infrastructure fund aimed at enhancing Germany’s infrastructure and stimulating economic growth.
To finance this initiative, Merz is attempting to amend Germany’s constitutional ‘debt brake,’ which traditionally limits new borrowing. The proposed amendment would allow defense spending exceeding 1% of GDP to be exempt from these borrowing constraints, effectively enabling unlimited borrowing for defense purposes. The outcome could have profound implications for Germany’s economic and defense policies in the coming years.
If the package is passed by the Bundestag, it would be the largest fiscal boost in 80 years – larger, even, than that associated with reunification.
It is not just Germany that is flexing its spending. European Commission president, Ursula von der Leyen, has proposed an escape clause for nations in danger of breaching the Stability and Growth Pact2 to allow them to increase their defence spending without triggering an Excessive Deficit Procedure (such a move was enacted during the Covid-19 pandemic when the European Union (EU) suspended its budgetary rules). She also announced common EU bond issuance for defence spending, and a call for more funding for the European Investment Bank is expected. There is even talk of a new bank for European rearmament that could include Norway and the UK, which would become a vehicle for military-specific bond issuance.
The market reaction to the proposals has been enormous. The government bond market has priced a once-in-a-lifetime shift in policy regime, and the jump in the 10-year bund yield of 30 basis points on 5 March was the largest single-day rise since German reunification was announced in 1990. Additionally, we saw the biggest three-day jump in the value of the euro for a decade, while interest rate swaps traded at -29bps versus 10-year bunds – a level not seen the early days of the Eurozone crisis in 2010. The difference between the German 30-year yield and the two-year yield has doubled since the start of the year (back to levels last seen when the European Central Bank had negative official interest rates) on the expectation that increased future issuance will tend to be at the longer end of the yield curve (Figure 1).
Figure 1: The global backdrop – trade restrictions have risen sharply
German 2s/30s yield curve steepening
Source: Bloomberg, as of 26 March 2025
The bottom line
All of these market moves have been of great interest to the global rates desk at Columbia Threadneedle Investments, and in particular our global aggregate strategies. The market outlook is for more volatility in bond yields, curve shapes, cross-market spreads and currencies. But with turmoil comes opportunity. Now is the time for active managers with a proven track record in the global aggregate space.
What trades benefitted in this environment
German yield curve steepener – as the burden on issuance is expected to be at the long end of the curve.
Cross market underweight Germany versus US – as the market viewed much greater fiscal stimulus in Europe relative to the US.
Euro swap spread tightener – as government issuance is expected to increase relative to corporates.
All three of these positions worked individually, but through using a risk-adjusted framework a combination of these positions was more optimal.
