The record-breaking rally for European government bonds is facing a major test, as euro-area nations turn to fiscal stimulus in the fight to revive the region’s struggling economy.
The Netherlands and Finland have already taken the first steps after the European Central Bank’s call for more spending. But strategists say any threat posed to the bond market bull run – from a sustained increase in supply at first and then via inflation – depends on Germany’s response.
Doubts about the ability of monetary policy to work any further are setting the tone for Mario Draghi’s last days as president of the ECB. His successor, Christine Lagarde, may use her background in charge of the International Monetary Fund to push for more government spending in Europe, even as the Federal Reserve continues to cut US interest rates.
German Finance Minister Olaf Scholz has pointed toward a potential €50bn ($55bn) of stimulus, but only in the event of an economic crisis. At the moment, the euro area’s biggest economy is still committed to its so-called debt brake. That has helped the federal government apply its “black zero” policy, which has kept net new borrowing at zero over the last five years. No net deficit is envisaged before 2023 at the earliest.
“To really see a ripple across bond markets, you need official confirmation that Germany is about to sacrifice the black zero and the debt brake with plans to launch a meaningful fiscal package worth double-digit billions by next year,” said Christoph Rieger, head of fixed-rate strategy at Commerzbank AG. “That’s still unlikely under the current government.”
A further sign of the growing struggles of monetary policy came yesterday, when the take up of new cheap loans from the ECB by banks totalled around €3bn. Analysts had expected lending of between €20bn and €100bn. Bonds in Italy declined after the long-term refinancing operation, known as TLTRO. Previous rounds have been widely used by the country’s banks, which are major buyers of their domestic sovereign debt.
“It underlines the longer term point that one central bank after another is effectively admitting they are not omnipotent,” said Marc Ostwald, a global strategist at ADM Investor Services in London. “If monetary policy is so complex for the banking system, then it is unlikely to have the impact that central banks want.”
Without a commitment of more spending from Germany, the overall dynamics in the bond market are unlikely to change, even as smaller countries ready their own response. The Netherlands has unveiled a proposal for a national investment fund, potentially as large as €50bn, while Finland plans to boost spending by €2.1bn. Italy is accustomed to playing fiscal tug-of-war with the European Union.
The adoption of such a policy from Germany would break into new territory, which bond bulls are watching. Any sustained rise in consumer prices erodes the fixed-income returns offered by bonds in real terms, adding to the relative appeal of rival asset classes.
That would likely coincide with increased demand for stocks and rising risk appetite across global markets. These trends would also reduce the need for bond-friendly monetary easing from the ECB, which has been one of the main drivers of the demand that has taken yields to record lows.
Such a set of game-changing circumstances remains remote, for now, and bond markets have been largely immune to talk of more borrowing. German 10-year yields are still 50 basis points below 0%, while those on Italian and Spanish securities have set record lows in recent weeks.
And doubts remain on any such fiscal stimulus working, should it be adopted. For Mizuho International Plc, signs of Germany loosening spending will boost yields, but may do little to revive the region’s economy.
“Germany would need to be breaching the stability and growth pact for there to be a material and sustained move higher in core EGB yields,” said Peter Chatwell, head of European rates strategy, referring to EU rules on deficits. “Monetary and fiscal easing can inject stimulus into the economy, but they cannot bring forward sufficient demand from future generations if the population will be shrinking.”
Nonetheless, the impact of any change of policy in Berlin could be immense. Global fund managers surveyed by Bank of America Merrill Lynch say German fiscal stimulus would be a greater boon to risk assets than infrastructure spending in China or aggressive central-bank policies.
Such findings are enough to give pause for thought to even the biggest bond bulls, especially after their long, record-breaking run.
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