Last week, the European Central Bank cut three key interest rates by 25 basis points. Normally, such a move would cause bond yields in Germany, France, etc., to fall. However, the opposite happened: government bond yields soared, while the EUR/USD reached last November's highs above 1.08.
Why did the markets react this way?
The European Commission's proposal for an €800 billion rearmament plan was a major catalyst. Markets tend to anticipate significant policy changes; this case was no exception. Not surprisingly, when the plan won formal “ok” at the March 6 summit in Brussels, the debt market reaction was muted.
The plan outlines €150 billion in loans, with an additional €650 billion to be raised over the next four years through various fiscal mechanisms. If approved, by 2028, EU defense expenditures could exceed €650 billion, more than double the €326 billion earmarked for 2024 and nearly four times the €279 billion spent in 2023.
To increase pressure on the European debt market, the future Chancellor of Germany announced the creation of a 500 billion euro infrastructure fund to be invested over the next ten years. The Bundesbank, in turn, proposed relaxing the so-called “debt brake” to finance these large-scale projects.
Currently, this rule limits the structural budget deficit to 0.35% of GDP, but the regulator now suggests raising the limit to 1.4% of GDP. This change could enable Germany to raise an additional €220 billion between now and 2030. The stock market is optimistic about this, but for obvious reasons, the debt market is less so.
The point is that the eurozone functions as a single entity with a shared currency and a unified monetary policy. Therefore, when one country has problems, it can also affect the others. If Germany, the largest economy in the region, increases its debt, it could lead to higher interest rates for all member states.
This could significantly hurt heavily indebted countries such as Greece, Italy, France, Belgium, and Spain. Even if this does not trigger an immediate debt crisis, it does increase Europe's vulnerability to external shocks. A sudden economic downturn, for example, in the US, could reignite fears of major problems in the EU.
In addition, the prospect of higher EU spending could increase inflationary pressures. This concern has likely led the regulator (ECB) to adopt a “less restrictive” policy. These actions demonstrate that the central bank is trying to balance supporting economic growth with managing inflation risks.