European Markets with Peter Schaffrik
Welcome back to European Markets. My name's Peter Schaffrik and today is the 20th of March 2025.
Today I'd like to talk about two things, the increase in fiscal spend that is likely to come out of Germany and Europe at large, and how it balances against the potential tariffs and obviously what it means for the economy and the market. Before we discuss that, let's take a quick look at the market, particularly at bond yields. We've seen a fairly significant jump. In fact, the largest jump in a long while in a one-day move after the German fiscal announcement. And what you see in the right-hand chart is also that it was a European-led move. In fact, a unique European move. Typically, US and European yields move quite closely together, not so this time round. We came back to the round about 3% level and we'll have to see where we're going from here.
Also, when you dig a bit deeper, what you find is the main reason for this increase was an increase in real yield, not necessarily inflation expectations, although they went up a little. On the back of that, the ECB has been repriced to some degree as well. We have long been expecting higher terminal rates from the ECB than what the market was pricing and the market has moved towards us. We think 325, which implies one more rate cut from the ECB, the market is currently pricing round about 210, and we think it will probably move further in our direction. But let's return to the market in a second, and let's take at what has been announced and what the potential macroeconomic implications are. What you've seen on the screen now is a rough summary of what has been announced from Germany, and the two main things are, one, a change in the so-called debt brake, which now allows for higher defense spending north of 1% of GDP to be excluded from the deficit calculation. Defacto, this means defense spending is now unlimited.
The second thing is a 500 billion infrastructure fund supposed to run over 10 years, roughly speaking, that's about one to one and a quarter percent of GDP per year, and we can have a big debate about whether that money is going to be spent quickly, whether the defense money is going to be spent mostly at home or some of that goes abroad, but we think when everything is said and done, we'll probably have a GDP lift in Germany of somewhere between 1.5 and 2% of GDP for quite a few years. Also important, as these programs are set for a very long period of time, we think it will draw in private sector investment as they build up production capacity, particularly in the defense industry, but also in others. Now, where does that leave us relative to tariffs? Now, the situation with tariffs is a bit more difficult. We do not know yet what will be announced. We do not know how long they will last, and we also don't know whether there's any room for negotiation.
But to put some numbers around it, the ECB has just told us that they expect a 25% tariff would be a hit of not 0.3% of GDP for this year, and would probably also increase to 0.5 if there were retaliatory measures in place, but that should be seen as a worst case. But again, the ultimate outcome is as of yet very difficult to assess. Where does that leave us? We have just upgraded our GDP forecast and you see them on the chart now. The increase for 2025 is to 1.5% growth and 1.9% for 2026. What you also see is that the increase that we have penciled in on the back of the fiscal expansion is probably going to be larger than the negative impact from the tariffs. Now, what does it mean for markets? We think it's still not a good time, despite the increase in bond yields to become constructive on bond markets.
The last chart that you're seeing now shows our forecast profile relative to deep forwards in the market. In fact, we have just upgraded our bond yield forecasts. We previously were expecting 3% to be reached by the end of this year. We brought that forward to the middle of this year, and now think the end of the year, we'll see something like three and a quarter, meaningfully above where the market is currently pricing the forwards. That means we remain cautious when it comes to duration investment. We prefer the short end of the curve. We prefer spread exposure and risky assets should still be doing quite well, even if the uncertainty ahead of the tariffs would make it difficult in the here and now. We shall return to that topic, I believe time and time again as the year progresses. But for now, I thank you for watching and I hope you're going to join me again next time.
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