European Markets Brace for Large Government Borrowing

Investors are preparing for European governments, led by Germany, to issue a large amount of new debt next year as they spend heavily to protect their economies from high energy costs.

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According to Danske Bank A/S, governments in Europe are expected to increase bond issuance by 10% to €1.2 trillion in 2023, equivalent to around $1.27 trillion. This comes as the European Central Bank plans to start shrinking its bond portfolio starting in March, which will reduce its role as a buyer of eurozone government bonds.
Germany announced last week that it would sell roughly €300 billion in bonds in 2023, a record amount. The new borrowing will help fund a €200 billion energy-relief package and additional spending on defense and climate-change projects.

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The recent surge in new debt issuance by the German government represents a departure from its previous fiscal conservatism, and could provide additional leeway for other eurozone countries to increase their own debt issuance. This is according to Piet Haines Christiansen, a fixed-income strategist at Danske Bank.
"This is a major shift for Germany," said Mr. Christiansen. "It provides other eurozone countries with some flexibility."

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According to the Brussels-based think tank Bruegel, European countries have set aside €705.5 billion to protect consumers from rising energy costs.
According to Danske Bank data, investors will need to absorb an additional €600 billion next year. This includes the effect of the ECB’s plans to shrink its bond portfolio by around €15 billion a month. The ECB isn’t planning to sell bonds outright, but instead will reinvest fewer of the proceeds from maturing bonds.
Since the ECB launched its bond-buying program in 2015, it has acquired more bonds than governments have issued, amassing a €5 trillion portfolio.

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The amount of bonds hitting the market next year will be the largest since the ECB launched its bond-buying program. This will be only the third time in the nine years since the program began that there will be more bonds sold than the ECB is buying. (The ECB doesn’t buy bonds directly from governments. It purchases them in secondary markets.)

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"It's a whole new world," said Mr. Christiansen. "The ECB was a huge, one-sided buyer that will no longer be an active player in pushing rates lower."
There is a worry among some investors and analysts that the current supply issues could lead to a full-blown eurozone debt crisis. This would force governments to borrow at higher interest rates, and investors could face even more volatility. An index of eurozone government bonds is down 16% this year, which is the worst performance in its 37-year history, according to index provider ICE Data Services.

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Orla Garvey, a senior fixed-income portfolio manager at Federated Hermes, does not believe that a buyers' strike is likely. However, she does think that buyers will demand a higher risk premium in light of the large supply of bonds. This may cause some disruption in the market, but it does not need to be a major issue.
The yield on Germany’s 10-year government bond has increased from negative 0.1% at the start of this year to 2.4% on Thursday. Italy’s benchmark bond yields have almost quadrupled, while Spain’s have increased nearly sixfold. Yields rise as prices fall.

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Italy's borrowing will remain in the spotlight as one of the eurozone's most indebted countries. Italy typically experiences more market volatility than other countries in the eurozone, and this week said it planned to sell up to €320 billion worth of bonds in 2023, compared with €285 billion this year.
Italy's bond yields have been rising at a faster pace than those of Germany, which investors watch as a key gauge of eurozone distress. This week, the 10-year Italian bond yielded 2.2 percentage points more than a similar German one, the largest difference since October.

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Konstantin Veit, a portfolio manager at Pacific Investment Management Co., doesn't expect major disruptions in bond markets as the increase in bond supply and the ECB's plans to start unwinding its bond portfolio have been well-telegraphed to markets. Veit believes that the market has already priced in the potential impact of these events, and as such, he does not expect to see any major surprises.

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"What matters more to Italy, for example, are the political developments in Italy or on the European level, rather than the supply picture or ECB involvement," he said. "I tend to think that you need a surprise for this to be particularly relevant."
In September, the U.K. offered investors a surprise when former Prime Minister Liz Truss laid out plans for tax cuts and an energy package that would have required a big increase in debt. However, just weeks later Ms. Truss's government scrapped the tax-cut plans after a historic selloff in U.K. government bond markets. Finally, in October she announced her resignation.

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Even without Ms. Truss's tax cuts, the U.K. is expected to issue £180 billion in new bonds in its fiscal year starting in April, up from £90 billion this year, according to data from JPMorgan Chase & Co. That includes the effect of bond redemptions and the Bank of England's bond-selling plans.

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David Coombs, head of multiasset investments at the U.K. fund manager Rathbones, said that he is buying U.S. Treasurys because he is concerned about the supply.
The yield on a 10-year U.S. Treasury note was at 3.667% on Thursday. This is similar to the yield on similar U.K. bonds, which is around 3.592%.
"I don't feel like I'm being compensated enough for the risk of lending to the UK government," Mr. Coombs said.