Germany’s relief plan could trigger a UK-style bond meltdown in euro nations

Amid downbeat predictions of a recession in Germany and the wider region, analysts at one Wall Street bank have shared wider concerns about violent bond market moves and European governments looking to borrow vast sums of money.

German Chancellor Olaf Scholz last week announced a package worth 200 billion euros ($198 billion) designed to help with soaring energy prices. The “defensive shield” includes a gas price brake and a cut in sales tax for fuel.

The proposals could cut 2 percentage points off inflation in the next year, according to Citi, but they are unlikely to prevent an economic contraction. The package “may soften the coming recession but also poses risks, in our view,” Citi analysts said in a note released last Friday.

Those risks relate to the question of how the package will be financed and what that could do to inflation, to Germany’s sovereign bond yields, to the European Central Bank’s benchmark rate, and to the borrowing plans of other euro nations that may do the same.

“The risk is that others may follow that example,” Christian Schulz, deputy chief European economist at Citi, told CNBC’s “Street Signs Europe” on Monday.

Schulz noted the U.K.’s recent bond market blowup after unfunded tax cuts by the British government. Rate expectations and bond yields surged in Britain last month after a swathe of tax announcements. It caused the Bank of England to unleash a new bond-buying plan, mayhem in the mortgage market and talk of a housing crisis.

Schulz said Germany could “afford” any debt financing thanks to its low debt-to-GDP ratio and lower external funding needs, but the package could open the door for less fiscally prudent countries to want to borrow large amounts and issue new debt — potentially leading to trouble like that seen in the U.K. Citi predicts that German debt financing could also force tighter ECB policy, which could then also send yields surging in the euro area.

“The risk is that this same dynamic [seen in Britain] evolves on the continent as well now,” Schulz said.

“The way [Germany] want[s] to do it is by using an existing SPV [special purpose vehicle], an off balance sheet fund …. whether that’s going to lead to borrowing or whether it’s going to lead to guaranteed loans — because this fund can do both — we shall see,” he added, referring to the 200 billion euro plan.

Germany’s Federal Audit Court criticized the government and suggested it had dodged tax rules to fund the package, according to Politico.

Other banks and institutions pointed to the difficult environment in Germany — the largest European economy and an engine room for euro area growth — which is now trying to abruptly wean itself off of Russian fossil fuels.

Berenberg Economics said in a recent note that consumer confidence in Germany, and the euro zone more generally, has plunged to a record low, which it said is “a prelude to recession.” Indeed, the Institute for Economic Research predicts investment will plummet by 25% and expects a German recession in 2023.

Deutsche Bank analysts estimate that the “defensive shield” could boost household income and limit the projected GDP decline in 2023 to around 2%. That’s better than their previous forecast of a 3.5% contraction.