After a long wait, Germany prepares to vote on Sunday.
As we mentioned previously, the election will constitute a critical change for the European bond market as the political focus notably shifted from austerity to the need to increase public spending. During the past decade, German public investments net of depreciation has been negative. The electorate is perfectly aware that specific issues such as climate change and digital policy require more significant investments. Therefore, parties broadly agree that public spending should increase, making a rise in Bund yields inevitable. Yet, the intensity of their rise may vary depending on the kind of coalition formed.
It's essential to remember that it could take weeks or even months for a new government to be formed. Thus, although volatility may rise straight after Sunday's results, Bunds might begin to fundamentally reprice later when we have a better picture of how the new government will be.
Possible coalitions and outcomes for the bond market:
- Germany coalition:CDU/CSU + SPD + FDP
- Kenya coalition: CDU/CSU + SPD + Greens
- Jamaica: CDU/CSU + Greens + FDP
- Traffic Light coalition: SPD + Greens + FDP
- R2G coalition: SPD + Greens + Left
The most bearish outcome for Bunds would be an R2G coalition, whether SPD will lead with a majority and govern together with the Greens and the left party. The R2G coalition would also be the least bearish scenario for the periphery. The three parties lean towards higher fiscal spending and better integration at the European level that would aim to reduce economic disparities among EU member states. That will minimize differential in credit risk between countries encouraging bond investors to sell Bunds to buy higher-yielding sovereigns in the Euro area, compressing spreads considerably. We expect the biggest beneficiary of this outcome to be the BTPS/Bund spread, which might fall to 50bps.
A Kenya coalition and a traffic light coalition would also be bearish for German bunds but to a lesser extent. Suppose the SPD manages to lead both coalitions. In that case, we can expect an increase in fiscal spending and European integration to be still a focus. However, topics such as joint debt issuance and making the NextGenerationEU fund a permanent instrument will be firmly opposed by the CDU/CSU and the FDP, providing less upside for the peripheral spreads versus Bunds. Within this scenario, we see 10-year Bunds breaking above 0% and stabilizing around 0.2%. The spread between BTP/Bund will tighten to 75bps.
The Germany coalition is a tough call. Such a coalition assumes the CDU/CSU will be the leading party. Yet, standing by the current polls, it's more likely that the SPD will be the leading party, flipping the black and red flag colour. It means that fiscal spending will be still relevant but contained. Policies that would reduce economic disparities within the EU, such as European joint debt issuance, unemployment insurance, and the NGEU, will be firmly opposed by the CDU/CSU and FDP. Within this scenario, Bund yields have the potential to rise and stabilize around 0%. Still, the spread of the periphery versus the Bund will be little changed.
Finally, the Jamaica coalition will be the least bearish scenario of them all, representing almost a "status quo". The CDU/CSU will be leading the government. Despite fiscal spending will still increase, the policies that the periphery would benefit from would be overlooked. Although the composition of the government would be different from today, it could be seen as a continuation of the current government, where the debt brake remains king. However, we believe that a Jamaica coalition is the least likely election outcome due to the reluctance of the Greens to partner up with two conservative parties. In this case, Bund yields will rise slightly but have the potential to remain negative. Spreads in the periphery might widen slightly, with Greece leading losses.
It’s not all about the German election: correlation between US Treasuries and Bunds remains high
The selloff in Bunds might accelerate as soon as yields resume to rise in the US, which we'll believe will happen by the end of October or November. Indeed, the correlation between the two remains exceptionally high, adding downside risks to Bunds. Therefore, investors have to be vigilant as soaring US yields might add up to news from Germany.
Conclusion: the German election will be bearish for the European bond market regardless of the result
We can conclude that the German election will be bearish for the European bond market regardless of the outcome. In all the scenarios we went through above, Bund yields will rise. Even in the most bullish scenario where peripheral spreads tighten versus Bunds, yields of these countries will need to increase substantially compared to current levels. For example, if a traffic light coalition sees Bund yields rising to 0.2%, and the BTPS/Bund spread tightens to 75bps, it implies that 10-year BTPS will rise around 1%, representing a loss of roughly 3% from current levels.