Germany is at a financial crossroads. Friedrich Merz and his CDU/CSU are pushing to relax strict debt rules to unlock billions in defense and infrastructure investment.
The clock is ticking ahead of Tuesday’s Bundestag vote. But on Friday, Merz reached agreement with the Greens. Without such a breakthrough, Merz would have been forced back to the drawing board to find alternative financing routes.
Germany’s long-standing aversion to debt began to erode during the pandemic when the EU temporarily relaxed fiscal rules. Now, as transatlantic alliances shift, Berlin’s traditional commitment to fiscal restraint appears to be fading.
Merz, widely seen as the frontrunner to become the next chancellor, wants to exempt defense and infrastructure spending from Germany’s constitutional debt limits. For investors, this shift is a clear signal to reassess their positions in German government bonds.
Bund yields jump after Merz signalled shift
The market’s response was immediate. After Merz announced his plans two weeks ago, German Bund yields posted their sharpest one-day increase since the 1990s, rising by 30 basis points. The 10-year Bund yield has since climbed further, hovering around 2.9 percent.
Change in yield on 10-year German government bonds
Bondholders already invested in Bunds took losses, while new investors saw opportunity. Laura Cooper, macro strategist at Nuveen, said German bonds had become “attractive,” citing Germany’s strong fiscal position and improved economic prospects, which made higher interest rates more manageable.
Cooper said she expected German yields to rise slightly further, potentially reaching 3.1 percent by year-end as bond issuance increased. Even at current levels, however, she said Bunds remained an attractive investment. When hedged to dollars, German Bunds now offered one of the highest yields among developed-market government bonds.
“There is a risk that European investments would overheat the economy.”
— Kaspar Hense, RBC Bluebay Asset Management
Kaspar Hense, portfolio manager at RBC Bluebay Asset Management, said Bund yields around 3 percent were a “fair valuation.” However, he warned against excessive optimism. While higher yields appealed to investors, he said the underlying fundamentals might be weaker than they appeared.
“There is a risk that European investments would overheat the economy. Investors might be better off shifting to equities, as interest rates could rise significantly beyond current levels,” Hense said.
Rising yields: Growth signal or fiscal concern?
Markets interpreted the rise in German bond yields less as a fiscal red flag and more as recognition of an improving economic outlook. Germany’s debt-to-GDP ratio remained low at 63 percent, among the lowest in Europe.
However, some economists suggested that the rise in yields reflected investor unease over Germany’s increasing bond issuance rather than confidence in economic strength.
“If borrowing only delays reforms, Germany risks doing itself more harm than good.”
— Friedrich Heinemann, University of Heidelberg
Friedrich Heinemann, economist at the University of Heidelberg, said higher borrowing costs would hit Germany directly. He argued that additional debt was only justified if it drove meaningful economic growth.
Heinemann was particularly skeptical of the SPD-Union coalition’s spending plans, suggesting that new subsidies and pension increases were unlikely to enhance Germany’s long-term growth potential.
Bundesbank President Joachim Nagel shared these concerns, warning that while borrowing might offer short-term relief, it risked creating long-term challenges. He called for structural reforms, particularly lower taxes, to support fiscal sustainability.
Heinemann also said Germany’s rising debt burden could further delay much-needed reforms in social security, regulation, and government efficiency.
Broader Eurozone impact
While Germany’s financial stability remained intact, rising Bund yields pushed up financing costs across the eurozone. Sylvester Eijffinger, professor emeritus of financial economics, said higher German rates could tempt other European governments to expand spending, potentially reviving discussions on joint European bonds and further eroding the already weakened Stability and Growth Pact.
“Those rules are practically dead,” Eijffinger said.
Although Germany could likely absorb higher rates due to its historically strict fiscal policies, the real risk lay with countries with weaker public finances, such as France and Italy.
Eijffinger said Germany’s fiscal discipline had given it ample room to manage rising borrowing costs. He sees it as “highly unlikely” that yields would retreat significantly in the near term.
ING strategists Chris Turner and Francesco Pesole agreed. They said the recent rise in yields was structural, not cyclical. They predicted that German rates would remain stubbornly above 3 percent, signaling a fundamental shift in the bond market landscape.
Opportunities in the periphery
Nuveen saw rising yields in peripheral European markets as an investment opportunity. The spread between German and Italian bonds had narrowed, indicating that investors were demanding less risk compensation for Italian debt—a sign of improving financial stability in Europe.
When asked about market opportunities, Cooper pointed to mid-tier Italian bonds as particularly attractive. She said the higher yields on these bonds outweighed the risks associated with potential trade tensions or widening spreads.
Bund auction as test
Last Wednesday provided the first major test of investor sentiment. Germany auctioned ten-year bonds worth 4.5 billion dollars to gauge demand. The bonds priced at a 2.92 percent yield.
The bid-to-cover ratio—a key measure of demand—stood at 2.1, lower than the previous two 10-year Bund auctions. This suggests that, despite rising yields, investor appetite for German debt had not significantly increased. If yields remained elevated, Berlin could face challenges issuing bonds in significantly larger volumes.