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Europe’s plan to spend more on its defence has poured fuel on a rise in countries’ long-term borrowing costs, investors say, adding to expectations that they will increase debt issuance.
Long-term borrowing costs for big economies such as Germany and the UK have been rising in recent months, driven partly by expectations of more sovereign debt supply.
Bets on increased defence spending have provided the latest catalyst, as US President Donald Trump pushes to end the Ukraine war and warns the region that it has been underpaying for its security. Yield curves on European sovereign debt have reached their steepest in two years this month, as long-term borrowing costs rise faster than short-term yields — a proxy for supply expectations.
“Higher deficits are coming, with the need to grow defence spending,” said Mark Dowding, chief investment officer for fixed income at RBC BlueBay Asset Management.
That, he said, was mixing with inflation risks and an “uncertainty premium” brought in with the new US administration to push up long-term borrowing costs.
RBC BlueBay has bet on steeper yield curves in Europe and the US this year, a popular bet for asset managers.
Germany’s 10-year bond yield has reached 2.5 per cent, from just above 2 per cent at the start of December. Its spread over 2-year yields has reached close to 0.4 percentage points, the biggest gap since late 2022. Anticipation of growing defence spending has piled on top of speculation in markets that the country will reform its constitutional “debt brake” and increase borrowing to back a fiscal stimulus package, following elections on Sunday.
“Although Germany has a low fiscal deficit, pressure to move wider on the long end comes as an increase in defence spending and uncertainty on the release of the debt brake portend more borrowing and wider deficits,” said Mitch Reznick, a fund manager at Federated Hermes, which is also running steepener trades on European debt.
The recent rise in long-term borrowing costs reflects “primarily the risk that the EU will need to announce a spending bazooka to meet its defence commitments,” said Pooja Kumra, a rates strategist at TD Securities.
Defence shares have surged this week, as investors moved to anticipate greater defence spending. But there is not yet clarity on the extent of the extra spending or how it will be funded.
The EU said last week it would temporarily ease its fiscal rules to allow countries to spend more on their defence. The UK has promised to set out a “pathway” to increase defence spending from 2.3 per cent to 2.5 per cent of GDP, but a move to loosen fiscal rules only established in October might be poorly received by investors.
“It’s another upward source of funding pressure on debt-to-GDP [ratios],” said Frank Gill, sector lead for European sovereigns at rating agency S&P. The EU, he said, needed a financing “initiative quickly to show that they are serious about increasing defence spending at the European level”.
Some form of joint debt issuance by European governments, potentially including the UK and Norway, is one of the options under consideration by officials.
Additional reporting by Paola Tamma in Brussels
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