German debt expansion disrupts European bond market: 10-year German bond yields expected to break 3% again after 18 months.

The yield of German benchmark bonds is approaching the key psychological threshold of 3%. If it surpasses this significant level, it will be the first time in the past 18 months. With market expectations that the German government will embark on a historic large-scale debt expansion and issuance wave to support economic growth and national defense, investor sentiment in the European bond market has significantly cooled recently, putting considerable pressure on German bond prices. On Wednesday, the yield on German 10-year bonds rose by 4 basis points to reach 2.93%, significantly exceeding the previous peak level reached last week, marking the highest level since October 2023. So far this month, the yield on German 10-year bonds has increased by a total of 53 basis points, making it the largest monthly increase in the past two years. The significant fluctuations in the German bond market stem from Berlin's imminent massive fiscal spending plan to boost investments in German defense and infrastructure. This plan is primarily led by the incoming German Chancellor Friedrich Merz. Although the German Green Party had initially rejected Merz's government's proposed fiscal reform plan, they then indicated they might reach a compromise as early as this week, causing German bond prices to fall further to new lows, indicating a substantial increase in yields. The German fiscal policy may undergo a significant stimulus shift, prompting investors to demand higher yields on long-term bonds to compensate for the risks associated with the expected surge in debt levels. Consequently, the spread between short-term and long-term bond yields in Germany has widened significantly in recent times, with the spread between the two-year and 10-year bond yields expanding to 70 basis points, the highest level since July 2022. Just a year ago, this yield curve was in an inverted state, with short-term bond yields far exceeding long-term bond yields. The surge in German bond yields has spilled over to other European countries, reflecting the widespread expectation among investors in the Eurozone that European countries will also significantly increase defense budgets in response to the changing NATO dynamics post-U.S. withdrawal. Over the past week, the yields on Spanish and Italian 10-year bonds have risen by approximately 40 basis points. Faced with this situation, some major institutional investors, including BlackRock, the world's largest asset manager, have begun to adopt a bearish outlook on the price trend of Eurozone bonds. Earlier this week, the head of research at BlackRock Investment Institute stated in a report that with the significant increase in defense spending across European countries and limited space for further interest rate cuts, the yield on 10-year bonds of key Eurozone economies may further rise. The key logic behind the trading of 10-year bonds in major Eurozone economies, such as Germany, in the Eurozone bond market is that a surge in government spending will lead to a sharp increase in long-term bond issuance which also means that the market will demand higher long-term bond investment returns, faster economic growth, and rising inflation both factors that compel investors to seek higher returns to hold long-term debt. In response to geopolitical upheavals and economic growth challenges, the German government announced an unprecedented fiscal expansion plan last Tuesday, pledging to amend the constitution and strengthen national defense at "all costs." This historic fiscal stimulus measure will not only deeply impact the German economy and defense system but also herald a major transformation in the economic and defense landscape of Europe and even the world. A recent research report released by the European banking giant Deutsche Bank indicated that this plan could be "one of the most important fiscal paradigm shifts in post-war German history," with the potential to surpass the significance of the "German reunification" 35 years ago. It may lead to an "unlimited" borrowing of funds for defense expenditure at a rapid pace. Reports suggest that over 1% of German defense spending may be exempted from the "debt brake" mechanism in the German constitution. Merz also stated that the major political parties had agreed to initiate a 500 billion (approximately $528 billion) infrastructure fund to invest in priority areas such as transportation, energy grids, and housing. For a long time, Germany has been renowned globally for its extremely strict fiscal discipline, limiting its domestic economic growth, especially since it has fallen into economic stagnation since the pandemic and the Russia-Ukraine conflict. Many investors have long urged Germany to relax its fiscal constraints, and Merz's ambitious fiscal plan is undoubtedly a proactive response to these calls, marking the breaking of Germany's long-standing "iron law" on government borrowing, with the new government led by Merz planning to amend the constitution, lift the debt restrictions on defense spending, and enhance Germany's defense capabilities. The slogan of "at all costs" in Germany has not only triggered a sharp reversal in the Eurozone bond market but also created significant turmoil in the foreign exchange market. Risk reversals in the foreign exchange options market show that traders' bullish sentiment towards the Euro has reached its highest level in five years. Top investment institutions such as Goldman Sachs, Mitsubishi UFJ Financial Group, and TD Bank have abandoned their previous pessimistic forecasts that the Euro will fall to parity with the dollar.