Looking back, the day that just passed may be recorded in European history

On March 5, 2025, a seemingly ordinary day, may leave a significant mark in the future history of Europe. On this day, the European financial market experienced a rare storm, with the epicenter being Germany, the "stabilizing force" of the European economy.

On Tuesday evening, Germany's incoming Chancellor Friedrich Merz called for "everything possible" to revive the economy and strengthen national defense, and the unprecedented fiscal expansion plan was viewed by Deutsche Bank as "one of the most important paradigm shifts in post-war German history", causing the German bond market to face the most severe turbulence since the fall of the Berlin Wall, with soaring bond yields triggering shocks across the entire European bond market.

Some market analysts believe that this signals a significant shift in Germany's fiscal policy, which could be a "game changer" for European defense and has epoch-making significance.

However, Goldman Sachs warned that for European countries already heavily indebted and needing to continue borrowing on a large scale, the surge in eurozone bond yields is undoubtedly bad news. If this trend continues, European countries with limited fiscal space and poor credit ratings may struggle to bear the high financing costs and face the risk of bond sell-offs.

German Bond Market Faces Its Biggest Shock in 35 Years

On Wednesday, the yield on 10-year German government bonds soared by 30 basis points, marking the largest single-day increase since March 1990.

This increase left the market astonished. In a research report released on March 4, Deutsche Bank stated that the extent of this planned transformation is comparable to the "reunification of Germany" 35 years ago, and it may lead to unlimited borrowing for defense spending at a rapid pace.

For a long time, Germany has been known for its strict fiscal discipline, which has also limited domestic economic growth. Many investors have been calling for Germany to relax its fiscal constraints. Merz's plan is undoubtedly a positive response to these calls and marks a break from Germany's long-standing "iron rule" on government borrowing.

This historic shift quickly triggered a chain reaction across Europe:

The yields on government bonds in France, Italy, and Spain all rose by more than 25 basis points.

The euro exchange rate surged, poised to achieve its best three-day performance since 2015. The risk reversal indicators in the options market show that market sentiment towards the euro has reached the highest level in five years. Institutions such as Goldman Sachs, Mitsubishi UFJ Financial Group, and TD Bank have all abandoned their previous forecasts that the euro would fall to parity against the dollar More importantly, the market has begun to reassess the direction of the European Central Bank's monetary policy. Traders have cut their bets on further interest rate cuts, with expectations of an 84 basis point cut by the end of the year now reduced to just 67 basis points.

"A Historic Significance"!

In response to this series of events, market analysts and economists have commented. James Bilson, a fixed income strategist at Schroders, stated:

"Even if these plans are adjusted during the implementation phase, this policy shift is clearly of historic significance... We believe this shift in focus is not only crucial for Germany but also provides stronger policy momentum for other Eurozone countries."

Christoph Rieger, head of interest rates and credit research at Commerzbank AG, pointed out:

"These ambitious plans indicate that the government is taking large-scale action, and fiscal capacity may be pushed to its limits in the coming years."

Jack McIntyre, a portfolio manager at Brandywine Global Investment Management, remarked: "This feels like a game changer."

Can Europe Handle the Surge in Bond Yields?

However, for European countries that are heavily indebted and continue to borrow on a large scale, the surge in European bond yields is not good news.

Currently, the German swap spread—an important indicator reflecting the attractiveness of German debt—has plummeted to a historic low. Additionally, the yield on German 10-year government bonds is now 12 basis points higher than the corresponding swap rate, the highest level since 2007.

The difference between yields and swap rates, known as the swap spread, is an important indicator of future bond issuance, as government bonds tend to weaken relative to swaps when the market expects more bond sales.

Market analysts point out that this reflects market expectations that the German government will issue a large amount of bonds, leading to a decrease in the attractiveness of bonds relative to swap products. Goldman Sachs analyst Alberto Bacis emphasized that Europe is significantly increasing leverage, and the surge in sovereign bond yields will pose a threat to this.

Bacis also warned that if bond yields continue to rise, three scenarios may occur:

Scenario 1: Some countries may struggle to bear the high financing costs, facing the risk of bond sell-offs. If the situation spirals out of control, market behavior similar to "bond vigilantes" may emerge—investors sell off to "punish" countries with poor fiscal conditions, which will first impact countries with limited fiscal space and lower credit ratings. This will also put pressure on the euro

Scenario 2: Germany may be forced to step in to rescue other European countries, taking on the national debt responsibilities of other nations.

Scenario 3: The market gradually returns to calm, with some retracing today's wild movements.

In response, financial blogger ZeroHedge commented that Germany is using the "Ukrainian crisis" as an excuse to incur massive debt, while Europe is known for experiencing sovereign debt crises at the worst of times. If inflation remains high, the yields on Germany's new debt may soon become unbearable, which means the European Central Bank will have to intervene and monetize Germany's deficit spending, just as it has done for most of the past decade.

Undoubtedly, March 5, 2025, is a day to remember. Germany's "fiscal pivot" will not only profoundly impact its own economy but may also reshape the entire economic and political landscape of Europe. This day may become an important turning point in European history, and its far-reaching effects will be tested by time