Update Bonds: German spending plan impacts bond markets

Recent announcements from Germany regarding debt issuance to finance its infrastructure and defence spending have triggered significant reactions in European debt markets with German yields climbing by as much as 40bps on some parts of the curve. Bonds from other European countries have reacted in a similar direction, although not as strongly as German bonds. The rationale behind this movement is that the anticipated future fiscal expansion in Germany should stimulate GDP growth and stabilise an inflation trend that had been declining. This has forced the market to reprice the European Central Bank's (ECB) rate cuts that were previously expected. Moreover, if more debt enters the market, a higher yield may be necessary to attract investors.

However, our economists present a contrasting view as tariffs imposed by the US could eventually slow down the EU economy. This slowdown could potentially allow the ECB to continue cutting rates, however, at a slower pace than previously projected. When it comes to the US, we believe that tariffs could have a stagflation effect, that is slowing growth and keeping inflation slightly higher. The US economy may bend but not break. Therefore, we don’t expect any dramatic outcomes caused by tariffs or even public sector layoffs, that would push the Federal Reserve (FED) to cut rates aggressively, and our outlook for the US remains tilted towards high rates.

Regarding credits, spreads across all risky assets remain expensive and stable at tight levels for now. We don’t expect any compression, and any measures implemented by President Donald Trump – whether related to tariffs or geopolitical issues – could serve a negative catalyst that might push spreads higher. Historically, when spreads in risky assets have reached these current tight levels, their excess returns have always been negative. While the exact timing for this to happen is hard to predict, it is likely to occur eventually. Therefore, we don’t recommend increasing allocations to these assets and we keep an underweight position in our portfolio. Our preference lies with safer European bonds, which are expected to offer similar returns to risky assets but without their downside risk.