Germany’s Spending Plan Reignites Jitters Over Periphery Debt

(Bloomberg) -- Germany’s new era of big spending is pulling up borrowing costs across Europe, reigniting jitters around fiscal stability on the continent’s periphery.

Yields on benchmark Italian, Greek, Spanish and Portuguese bonds are over 30 basis points higher compared to the start of the month. The four countries, which were bundled together during Europe’s sovereign debt crisis more than a decade ago, still have some of the highest debt loads on the continent, making them vulnerable to higher interest rates.

Germany has long been the voice of fiscal discipline in the European Union — pushing for countries like Italy and Spain to tighten their purse strings and opposing the issuance of joint debt. But if that policy led to complaints of weak growth, the new, more relaxed approach to spending could have negative implications of its own for Europe’s most indebted countries.

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

While Germany’s yields have also jumped, consensus in the market is that Europe’s biggest economy can afford to spend billions more euros on defense and infrastructure following years of austerity. The risk is that the move could have repercussions beyond Germany’s borders, especially when European leaders are supporting a plan to loosen budget rules to allow others to spend more on defense.

“Germany is one of the world’s strongest credits, it’s got so much fiscal headroom,” said Colin Finlayson, a fund manager at Aegon Asset Management. “If some of the other European countries attempt to try and follow Germany’s lead, I don’t think it would be as universally well accepted.”

It’s not just the periphery that’s at risk. Debt levels in France and Belgium have ballooned in recent years, putting both countries ahead of Spain and Portugal in terms of debt-to-GDP. A blowout in French bonds last year showed just how quickly bond vigilantes can resurface when highly indebted countries announce plans to increase spending.

Recent analysis by Eurizon SLJ Capital Chief Executive Stephen Jen found that of the major 27 EU member countries, only Germany, the Netherlands, Sweden and Ireland have fiscal space to meaningfully increase fiscal spending. He argues that a rise in bund yields could lead to a widening of interest-rate spreads and greater financing burdens for other parts of Europe, with France, Spain and Greece amongst the most vulnerable.

“Germany stepping on the gas pedal will elevate the entire interest-rate spectrum in Europe,” Jen said in an interview. “We’ve witnessed what the bond vigilantes can do.”

EU finance ministers have also expressed concern that bond investors will be reluctant to finance more defense outlays and officials in Brussels said they fear a broader ramp up in spending would deepen the bond market selloff.

The jitters risk derailing a popular trade that periphery bonds will outperform due to relatively high growth rates. Spreads between German and periphery debt have shrunk over the past two years, with the extra yield investors demand to hold Italian debt dropping to around 110 basis points, close to half the level it traded at two years ago.

Some money managers say they aren’t concerned about the destabilizing effect of an increase in spending because looser fiscal policies will also promote faster growth. They point to the fact that yields have risen in unison across Europe, with little movement in the spread, as evidence that the periphery isn’t particularly at risk. 

“Fiscal is an issue for many countries but I think defense spending will be accepted as OK,” said Lynda Schweitzer portfolio manager at Loomis, Sayles & Company, who has exposure to Spanish, Italian and French bonds. “The periphery should hold up versus Germany.”

Aegon’s Finlayson is among investors hoping the EU will issue joint debt to avoid individual countries having to borrow more. This would require unanimous support from all member nations and, given that Germany is funding its own defense plan, some are skeptical it would also be willing to back a joint program. 

Some countries are getting creative with ways to fund more defense spending without irking investors. Belgium is reported to be considering the sale of a portion of its gold reserves to bolster its defense budget, while Italy presented a proposal to leverage private capital via a multi-layered structure of state and EU guarantees. The EU has also issued a proposal to extend €150 billion ($158 billion) in loans.

“Debt levels are extremely high and we spent most of last year talking about how to reduce them,” said Alex Everett, a fund manager at aberdeen group plc. “If we can avoid a situation where France, Italy and everyone else are being pushed that bit harder to borrow on their own, that would be preferable.”

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