German election updates
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Investors are bracing themselves for the fallout from a highly unpredictable German election this weekend, with some analysts saying that Europe’s bond markets are already hinting at a political shift in the region’s largest economy.
Sunday’s vote remains wide open, leaving fund managers reluctant to make firm bets on the dizzying array of potential coalitions that could take months of post-election horse-trading to form. Even so, a late surge by the Social Democrats in the polls has left investors anticipating a left-leaning governing alliance. This could usher in a more free-spending era in Berlin that breaks with the emphasis on debt reduction that characterised Angela Merkel’s 16 years in power.
“I think there’s going to be a political shift whatever the outcome,” said Gareth Colesmith, head of global rates at Insight Investment. “The question for markets is how big.”
The rise of the SPD, led by Olaf Scholz, in the final weeks of the campaign has coincided with “a notable shift in gear” in the market for Bunds, as German government bonds are known, according to Richard McGuire of Rabobank. A sell-off that began in late August pushed the country’s 10-year yield to a three-month high of minus 0.25 per cent on Thursday.
At the same time, inflation expectations derived from German inflation-protected government bonds — known as break-evens — have increased sharply, hitting their highest level since 2013 at just above 1.6 per cent over the coming decade.
These moves are partly down to global forces which tend to drive the world’s big bond markets in unison. But the rise in German yields and break-evens has outpaced other big markets such as the US, suggesting the election has injected uncertainty into a typically staid market, McGuire said. “Investors are requiring greater compensation when trading Bunds owing to the difficulty in predicting the near-term direction of German policy,” he added.
The make-up of any coalition with the SPD will be crucial. Another “grand coalition” with Merkel’s Christian Democrats would probably signal continuity, particularly as Scholz himself is hardly considered an advocate of free spending. The fiscally conservative Free Democrats would also likely be a restraining influence.
The Greens, who briefly topped polls in the spring, could nudge the SPD in the other direction, as the only party to call explicitly for long-term reform of Germany’s constitutional “debt brake” on spending, a rule that has been temporarily suspended during the pandemic. And any sign that the hard-left Die Linke might be called upon to join the new government would be taken by markets as a sign of much greater fiscal radicalism.
“If you get a centre left-led government, even if it includes the Free Democrats, it will be more prone to spend money,” said Peter Schaffrik, macro strategist at RBC Capital Markets.
Schaffrik said that the biggest reaction might not be in Germany’s home bond market, but in riskier debt elsewhere in the eurozone, given that the SPD and Greens are more receptive than the centre-right parties to a greater role for borrowing and spending at the EU level. German backing for shared borrowing would boost the bonds of countries such as Italy and Spain, he said.
Most investors are not anticipating a sudden surge in German borrowing costs, which at the 10-year maturity have languished below zero for more than two years. However, a turn away from Berlin’s frugality could help alleviate a shortage of German debt, coveted by investors as the eurozone’s ultimate safe haven.
“Part of the reason Bunds trade at such low yields is scarcity — there are not enough German assets to satisfy demand for them,” said Mark Dowding, chief investment officer at BlueBay Asset Management. “Creating some more of them could see that ease.”
Even so, Dowding said investors should be wary of betting heavily against Bunds unless a dramatic borrowing splurge is on the cards, particularly given the European Central Bank’s continued presence as a bond buyer. Such a scenario is only likely if a “red-red-green” coalition of Social Democrats, Die Linke and the Greens is in the offing, according to Dowding.
“Anything else would be business as usual,” he said.