A spectre is haunting Europe — the spectre of Russian aggression. As Russia looks beyond its borders, the US looks ever more inward. For Europeans, this is — at the very best — economy-changing.
After almost 80 years of policing the world, the US can no longer be relied on to defend Europe. “I just hate bailing Europe out again,” groused US vice-president JD Vance in ‘top secret’ Signal messages accidentally leaked to US magazine The Atlantic earlier this month.
President Harry Truman's post-Second World War doctrine of assisting “free peoples” and allies in their struggles against totalitarianism, which shaped US foreign policy for much of the 20th century, is giving way to a policy of America First, marked by tariffs and the US gradually withdrawing from the world stage.
Pressure is now on countries that previously called the US a close ally to build their own defensive umbrella.
The breathtaking cost of this is the most powerful force driving Europe's financial markets this year.
Germany’s Bundestag and Bundesrat last week approved a sweeping reform of its constitutional debt brake, to free defence spending from constraint.
While they were at it, Germany's dwindling majority of moderate legislators voted through €500bn of infrastructure spending over the next 12 years.
Much of this is likely to be funded by increased Bund issuance.
Five hundred miles away in Brussels, the EU unveiled an €800bn plan to boost Europe’s defences. It includes €150bn of loans to EU member states funded by EU collective borrowing under a new Security Action for Europe (SAFE) programme.
Other countries around the globe have unveiled similar plans, many of them involving extra borrowing.
Fiscal brake off, monetary brake on
The effect on sovereign bond yields has been dramatic.
The 10 year Bund ended February at 2.39%, according to Tradeweb. Earlier this month it hit 2.9%, as high as it got in October 2023.
But whereas that peak happened when central banks were raising interest rates hand over fist to grapple inflation, now they are trying to loosen the reins and let the economy run.
This is a shoulder barge to Europe's economy as it tries to get back on the growth track.
Already, capital markets are feeling the squeeze. It is more difficult for public sector bond issuers to price debt, and they are having to pay way more relative to their internal floating rate benchmarks. Sub-Euribor funding is long gone.
The same goes for covered bond issuers which fund a big slice of the continent's mortgages.
In credit markets, investor appetite is still rampant — bankers have got bored of saying it's baffling, and are getting used to it.
But even if the usual measures of a bond issue's success — spread, oversubscription, new issue premium — all look amazing, they hide the truth that borrowers are paying up in yield.
In equity capital markets, IPOs are being postponed because of the uncertainty caused by the US's game of tariff hide-and-seek, and that is also deterring M&A, keeping syndicated loan desks quiet.
Don't run away
Financing officials surveying this scene with dismay could easily turn their backs on the markets for a few months, hoping to come back later and find them in a better mood.
That would be a mistake. The defence costs and political uncertainty — and the internal strife both will bring — are not going away.
Overall rates could fall again, but that would be most likely if Europe dips into a slowdown — a disaster for the continent, as this was the year when growth was supposed to perk up from its barely perceptible level in the past two years.
A downturn might raise credit spreads — though probably not disastrously for investment grade borrowers.
But much more seriously, it would put even more strain on Europe's groaning government finances.
One way or another, funding costs are likely to stay higher for longer, and volatility will be ever-present.
Borrowers have shown a willingness to adapt before.
Last November, when Germany’s traffic light coalition collapsed, the pace at which Bund yields rose outstripped the rise in the swap rate, turning the spread between them at 10 years negative for the first time.
The freak reversal contradicted all financial market textbooks — but the spread has remained negative, at minus 9bp on Tuesday, according to Tradeweb.
The initial upset slammed the door shut on highly rated bond issuance. Public sector benchmarks tapered off in November, while covered bonds ground to an almost complete stop, bar a pricey deal from Caffil.
Many feared the malaise would seep into 2025 — but after a cautious start, issuers crowded into the market, and each deal appeared to improve on the last.
The market now faces a similar dilemma. Markets look uncertain, the political and economic outlook ugly and ominous.
But rather than queasy denial, what Europe needs is to roll up its sleeves and set to work confidently to make the best of its altered future.
In capital markets, that means not being put off by recent uncertainty, but accepting the new normal — and even embracing it.