By Dhara Ranasinghe
LONDON (Reuters) – For months, global bond yields have moved one way – down. Now, signs that Germany may finally be prepared to accept higher spending to boost its economy means investors are starting to question whether entrenched market pessimism is justified.
Economists have for years called on thrifty governments, above all euro zone powerhouse Germany, to spend more to shore up domestic growth, rather than relying on central bank policy to do the trick. After all, a decade of monetary stimulus has not meaningfully eased the economic funk, many argue.
For bond investors, extra spending is not just about the increased supply, however limited, that pushes up yields, but also the signal that a commitment to boosting economic growth has on sentiment and market pricing of economic conditions.
A German official has told Reuters Berlin might issue new debt to finance a costly climate package.
Britain’s new prime minister has vowed to increase spending ahead of its exit from the European Union after a decade of austerity, and France and Spain have also expanded expenditure. Italy is pushing hard to be able to run bigger budget deficits.
A U-turn from Germany, devoted to balanced budgets since 2014 – the so-called black zero – would be a far bigger deal, and many remain sceptical it will materialise.
But the implications are huge – further media reports that Berlin might take on new debt lifted bond yields worldwide on Friday, boosted stocks and expectations of future euro zone inflation <EUIL5YF5Y=R>, although German Chancellor Angela Merkel has so far fended off the calls for more fiscal stimulus.
Essentially, even a small shift in fiscal stance from the euro zone’s biggest economy and its benchmark bond issuer would mean it is time to question bond markets’ one-way direction.
“Aggressive German fiscal stimulus would be a game changer and should be on your radar for 2020,” said NatWest global head of desk strategy Jim McCormick, who has been selling five-year German bonds versus U.S. bonds to play possible German fiscal expansion.
Currently, more than $15 trillion (£12.3 trillion) worth of bonds globally carry negative yields. In counties such as Germany, the Netherlands and Switzerland, every government bond yields less than zero as investors have bought longer and longer-duration debt to grab an extra few basis points of yield.
For a graphic on European govt bond yield curves, click https://fingfx.thomsonreuters.com/gfx/mkt/12/4960/4917/curves2008.png
Bigger German budget deficits will almost certainly lift bond yields, but they are still seen as a good thing for Europe, not least if they provide relief to banks, insurers and pension funds which have all suffered from negative interest rates.
Mark Haefele, chief investment officer at UBS Global Wealth Management, also says government action on infrastructure should boost returns on investments such as clean energy.
Any extra borrowing is seen benefiting green projects and markets could get some clues on Sept. 20 when German coalition parties meet to agree steps on fighting climate change.
“CLEARDIRECTION OF TRAVEL”
Berlin will almost certainly be pushed to run a more proactive fiscal policy by incoming European Central Bank chief Christine Lagarde, when she takes over in November.
But what might convince Berlin it is time to pull the fiscal lever is growing recession risks – the economy shrank in the second quarter and the Bundesbank is warning of a contraction in the third quarter too.
“You have a perfect storm for (fiscal stimulus) to work — when Germany was growing strongly it was easy to say they don’t need stimulus but that’s not the case now,” said David Zahn, head of European fixed income at Franklin Templeton.
What is more negative interest rates – meaning investors pay governments to hold their debt – are a perfect opportunity to borrow and invest without impacting debt sustainability in many countries.
ING Bank analysts calculate in fact that Germany could run a fiscal deficit of 1.5% of GDP, swinging from a fiscal surplus of 1.7% in 2018, without worsening its debt ratio of around 60% of annual output.
This year, its sovereign interest payments will amount to some 0.8% of GDP, ING says, less than a third of 2008 levels.
For a graphic on Germany’s debt-to-GDP levels, click https://fingfx.thomsonreuters.com/gfx/mkt/12/4964/4921/Germany2008.png
Germany’s overall debt-to-GDP ratio is expected to fall below the EU’s crucial 60% threshold this year, giving Berlin more leeway for future spending.
“Markets are literally screaming at the German authorities to loosen the fiscal purse strings although to date this has fallen on deaf years,” said Mark Dowding, co-head of investment grade debt strategy at BlueBay Asset Management in London.
“We believe there is now a clear direction of travel.”
Increased government spending usually sparks alarm in bond markets, sending yields spiralling higher.
Expected ECB stimulus will keep downward pressure on yields.
Also, hardly anyone expects some extra German borrowing to derail the bond bull run; Finance Minister Olaf Scholz mooted stimulus of up to 50 billion euros, that too only in a crisis.
Templeton’s Zahn expects some selling at the margin, adding that “you would have to be talking about spending programmes in the trillions to really push it up (yield)”.
Instead, gross German debt supply should clock in at 168 billion euros next year, up from 161 billion euros in 2019, according to Commerzbank.
For an interactive version of the chart: https://tmsnrt.rs/2NpS1Nf
For a graphic on Gross German Bund issuance per year, click https://fingfx.thomsonreuters.com/gfx/editorcharts/EUROPE-FISCAL-BONDS/0H001QER77ZM/eikon.png
Investors in fact might welcome more debt from Germany as that would alleviate a scarcity of top-rated European debt, and at least start to make a dent in the mammoth pool of negative-yielding bonds.
“Clearly we need fiscal policy to come to the rescue if we want to get out of negative rates at some point,” said Marie Owens Thomsen, global head of investment intelligence at Indosuez Wealth Management.
(Reporting by Dhara Ranasinghe; Additional reporting by Tommy Wilkes; Editing by Sujata Rao and Alison Williams)