Whatever It Takes, the German edition

Overnight, the CDU/CSU (the winner of the latest German election) and the SPD (the leader of the current parliament set to end on March 25) announced Germany’s largest fiscal policy shift in decades.

Before the current parliament ends, they intend on approving three major measures. First, launching a €500bn infrastructure investment fund to be deployed over 10 years. Second, reforming the country’s “debt brake” to exclude defence spending over and above 1% of GDP from the calculation, effectively making defence spending open-ended from a domestic point of view (though EU-level restrictions will still apply). Third, allowing a 0.35% deficit for local governments which at present cannot run a deficit at all. Technically, the support of the Green Party is needed to get these measures passed in parliament, but given its views on the debt brake and infrastructure spending this is being seen as a formality.

Both the numbers and the change in attitude are significant. As we have argued in the past, Germany needs to invest more and save less, and compared to G7 peers it is in the rare position of having have ample room to do so. While more details are needed to properly assess the impact of the changes on the economy and what the fiscal deficit might be, at first glance it seems most of the potential growth impact will be felt with some lag as investment takes time to materialise. A rough estimate from JP Morgan on Wednesday morning suggested the deficit could reach 5.5% of GDP, though again this is not their base case necessarily as more information is needed.

Post-election, the running assumption that we and most market participants were making was for more fiscal spending and some changes to the debt brake, but overall the numbers involved were not expected to be huge. While these measures won’t have quite the same market impact as Mario Draghi’s famous “whatever it takes” speech in July 2012, the new government is doing a passable imitation in terms of the numbers being floated and the degree of departure from Germany’s recent fiscal norms. Markets reacted accordingly in early trading on Wednesday with stocks up, credit spreads tighter and Bunds selling off significantly at the open. There is uncertainty as to when exactly additional Bund supply will hit the market, but the direction of travel is pretty clear.

For investors, the key development to watch from here will be whether this changes the European Central Bank’s (ECB) monetary policy stance. As mentioned earlier, details are still scant. We therefore doubt the ECB will adjust immediately, but there is a chance it eventually will. In a speech last week, board member Isabel Schnabel pointed out that increased government bond supply is part of the explanation as to why r* (the real interest rate to which the economy is expected to converge in the long run once current shocks have run their course) is higher today than it was pre-2008. So far, terminal rate expectations for the Eurozone have moved up by just over 10bp which is not a particularly sharp move. Markets still expect the ECB to cut by 25bp tomorrow, and we still agree. But this massive fiscal plan comes at a time when inflation is not yet at target, which has to factor into the central bank’s thinking.

From an international investor point of view, the yields on euro denominated assets look attractive. Rolling a monthly EUR/USD FX forward adds about 200bp to euro yields when hedged back to dollars, and yields have moved up significantly on this news. We continue to believe the best way to extract the attractive returns on offer in Europe is through credit rather than government bonds, with high all-in yields supported by an economic tailwind that should continue to drive robust credit metrics.