Germany's Spending Surge Raises Borrowing Costs Across Europe

Germany’s new era of expansive spending is pushing borrowing costs higher across Europe, reigniting fears of fiscal instability, particularly among the continent’s most indebted nations. Yields on benchmark bonds from Italy, Greece, Spain, and Portugal have surged by over 30 basis points since the start of the month, with these countries still burdened by some of the highest debt levels in Europe. This makes them especially vulnerable to rising interest rates.

Historically, Germany has been a staunch advocate for fiscal discipline within the European Union, urging countries like Italy and Spain to tighten their budgets and opposing the issuance of joint debt. However, the shift to a more relaxed fiscal approach in Germany—driven by increased spending on defense and infrastructure—could have ripple effects for the eurozone’s peripheral economies.

“If Germany embraces deficit spending, other nations may follow suit, leading to a more relaxed approach to debt across Europe,” said Robert Burrows, portfolio manager at M&G Investments. He noted that he has reduced his holdings in peripheral debt due to the growing risks. “This could weaken confidence in European government bonds, raising borrowing costs for highly indebted nations.”

While Germany’s yields have also climbed, many investors believe the country’s robust economy allows it to afford billions more in defense and infrastructure investments. The real concern lies in the potential knock-on effects for other nations, particularly as European leaders discuss loosening budgetary rules to allow increased defense spending.

“Germany is one of the world’s strongest credits; it has significant fiscal headroom,” said Colin Finlayson, a fund manager at Aegon Asset Management. “But if other European countries try to follow Germany’s lead, it may not be as well accepted.”

The risks extend beyond Europe’s periphery. France and Belgium have seen their debt levels grow substantially in recent years, surpassing those of Spain and Portugal in terms of debt-to-GDP. The rapid rise in French bond yields last year highlighted how quickly investors can react negatively to plans for increased spending in highly indebted countries.

Recent analysis by Stephen Jen, CEO of Eurizon SLJ Capital, revealed that only Germany, the Netherlands, Sweden, and Ireland have the fiscal capacity to meaningfully increase spending. He warned that higher bund yields could widen interest-rate spreads, raising financing costs for more vulnerable countries like France, Spain, and Greece.

“Germany stepping on the gas pedal will elevate the entire interest-rate spectrum in Europe,” Jen said. “We’ve seen how bond vigilantes can quickly surface.”

EU finance ministers have also voiced concerns that bond investors may become reluctant to finance further defense spending, fearing it could exacerbate the ongoing bond market selloff.

These concerns threaten to undermine the recent trend of narrowing spreads between German and peripheral debt, which has been driven by relatively high growth rates in southern Europe. The gap between German and Italian debt yields has shrunk significantly in the past two years, dropping to around 110 basis points, nearly half of what it was two years ago.

Despite the concerns, some investors are less worried about the destabilizing effects of increased government spending. They argue that looser fiscal policies could promote faster economic growth, pointing to the fact that yields have risen uniformly across Europe, with little change in the spread between core and peripheral debt.

“Fiscal issues are a concern for many countries, but I think defense spending will be viewed as acceptable,” said Lynda Schweitzer, portfolio manager at Loomis Sayles & Company, who holds Spanish, Italian, and French bonds. “The periphery should perform similarly to Germany.”

Others, such as Aegon’s Finlayson, are hoping the EU will consider issuing joint debt to prevent individual countries from bearing the full brunt of increased borrowing. However, this would require unanimous approval from all member states, and some remain skeptical, especially with Germany already focused on funding its own defense initiatives.

Some countries are exploring innovative ways to fund additional defense spending without alarming investors. Belgium is reportedly considering selling part of its gold reserves to finance its defense budget, while Italy has proposed using private capital through a multi-layered structure of state and EU guarantees. The EU has also suggested extending €150 billion ($158 billion) in loans.

“Debt levels are extremely high, and we spent most of last year discussing how to reduce them,” said Alex Everett, a fund manager at Aberdeen Group plc. “It would be preferable to avoid a situation where countries like France and Italy are pressured even further to borrow on their own.”