Germany’s decision to hold early elections on 23 February could reshape its economic and fiscal policies, with potential implications for German Bunds’ role as Europe’s fiscal anchor.
In times of uncertainty, investors have historically turned to Bunds, the benchmark for European government bonds, as a safe haven. Their high liquidity and tendency to appreciate during crises have cemented their status as a stabilising asset in Eurozone portfolios. However, recent political turmoil in Berlin, coupled with economic challenges, has started to erode this trust.
“Fears are that Germany might well have to spend its way out of looming trade or geopolitical crises in the wake of the US election outcome,” said Benjamin Schroeder, senior rate strategist at ING.
Since early October, investor sentiment towards Bunds has shifted noticeably. Prices have fallen in recent weeks, pushing the yield on the 10-year Bund—a key market gauge—up nearly 40 basis points to 2.37 percent, its highest level since July, although this week it declined again to 2.28 percent.
Rate swap conundrum
An emerging focus for fixed-income strategists is the yield gap between Bunds and swap rates, particularly Overnight Index Swaps (OIS). Institutional investors rely on swap transactions to exchange fixed-rate interest payments for floating rates, managing interest rate risk and adjusting to market conditions.
Currently, the 10-year swap rate, at 2.32 percent, has fallen below the yield on Bunds. This negative swap spread, an unusual occurrence, has raised concerns about Bunds’ role as the Eurozone’s ultimate safe asset.
Commerzbank analysts see this as a “definite warning signal”.
“When investors are no longer willing to accept Bund yields below swap rates, it’s a sign that Bunds are losing their status as the safest asset in times of crisis,” Hauke Siemssen, a fixed-income analyst at Commerzbank, told Handelsblatt.
Robert Burrows from M&G’s bond vigilantes team told Investment Officer that this tightening of swap spreads also reflects broader market dynamics. “We have seen swap spreads tighten across the board,” Burrows said. “This is partly a result of Bund yields moving higher but also swap rates moving lower, driven by continued demand for pension liability hedging.”
Burrows also links the trend to concerns over fiscal sustainability. “Governments having to issue meaningfully more debt leave investors questioning the long-term sustainability of ever-increasing debt levels,” he said.
A political turning point
The collapse of Germany’s government has brought its fiscal policy into sharp focus, with early elections in February expected to determine its future course. One camp favours adhering to the debt brake—a constitutional limit on federal deficits—while the other argues for loosening fiscal policy to support a struggling economy.
M&G’s Burrows argues that the market could tolerate increased borrowing if managed carefully. “Germany’s low level of debt affords it the luxury of being able to borrow more,” he said. “If the relevant guardrails are in place and strict guidelines constitute acceptable borrowing for growth, it should be tolerated.”
Burrows estimated that Germany could add roughly 5 percent to its current 60 percent debt-to-GDP ratio—equivalent to 208 billion euro in additional spending—without significantly disrupting the bond market. “Interest rates remain low by historical standards, making the debt affordable at these levels,” he noted.
However, the challenges facing Germany extend beyond fiscal policy. Stefan Hofrichter, head of global economics & strategy at Allianz Global Investors, highlighted structural issues such as high energy costs, bureaucratic hurdles, and a shortage of skilled workers. Germany’s reliance on low energy costs and export dependence on China has left it vulnerable in a changing geopolitical landscape.
‘Clear reorientation’ needed
“Russia will be absent as an energy supplier for a long time, China has become a competitor in many industrial sectors, and defence spending needs to increase massively. All this weighs on the growth outlook,” Hofrichter said.
Despite these headwinds, Hofrichter remains cautiously optimistic. “What is needed is a clear reorientation of the economy, but this is entirely possible,” he said, drawing parallels to Germany’s transformative “Agenda 2010” reforms two decades ago.
Burrows, meanwhile, is not convinced about investing in German government bonds at present. “Europe has been the growth laggard amongst the majors and monetary policy has responded accordingly with 75 basis points of cuts to date,” he said. “Germany has one of the lowest 10-year rates amongst the developed world and currently offers little value at these levels.”