Update Bonds: Trump and Europe’s fiscal crossroads
Trump's election victory sent shockwaves through the bond markets, causing a sharp steepening of the US yield curve. It’s not over yet. His unpredictable stance on tariffs reverberated across the Atlantic, impacting European yield curves as well. In recent weeks, persistently high inflation in both the US and eurozone has added fuel to the fire. While the US has seen some relief with a slight reversal of the steepening, Europe tells a different story.
The self-proclaimed "dealmaker," Donald Trump, has now set his sights on EU defence spending, demanding not only a bigger financial commitment but also active involvement in rebuilding Ukraine post-conflict. Meanwhile, Germany, once the stalwart leader of the EU, finds itself in a state of paralysis, caught in the throes of election fever with polls suggesting Friedrich Merz of the CDU is the frontrunner for Chancellor.
About a year ago, Merz firmly opposed changing the debt brake. (In short, the debt brake limits the federal government’s deficit and stops German regions from running budget deficits.) Recently, however, the CDU's chancellor candidate has shown more openness to reform. While most parties support investment strategies similar to Draghi's plan and oppose the debt brake, only the right-populistic AfD remains firmly against loosening it. Consequently, Merz could be pivotal in reforming the debt brake, securing a two-thirds majority, and facilitating structural reforms in Germany, potentially leveraging EU bonds.
This perfect storm of uncertainties is causing the long end of the European yield curve to climb. The debate over Germany's debt brake, the potential mutualization of EU debts to kickstart Europe's economy, increased defence expenditures and support for Ukraine are all contributing to higher risk premiums, driven by fiscal uncertainties. The markets are on edge, waiting to see how these geopolitical and economic dramas will unfold.
European investors can still anticipate a divergence in monetary policy between the European Central Bank (ECB) and the US Federal Reserve. While it is unlikely that there will be any rate cuts in the US this year, we continue to expect monetary stimulus from the ECB and six more rate cuts in 2025. Therefore, despite the increased steepness of the yield curve, we are more comfortable with European sovereign bonds, particularly because spread risks are higher in Europe than in the US.