Europe exempted defence from its debt rules, and the term premium pays

The noise is in the rate decision, the signal in the budget tables

The question the market is debating this week is whether the ECB will raise rates on 29 October. In Reuters' 5–8 October poll, 70 of 73 economists expect the deposit rate to stay at 2.50%, and 64 expect a 25 basis point hike in December. The direction of this debate is 96% settled. And the policy rate only sets the short end of Europe's borrowing costs.

The real information sits in the fiscal section of the account of the 9–10 September meeting, which the ECB published on 8 October. It expects the euro area budget deficit to rise from 3.0% in 2025 to 3.6% in 2026, 3.7% in 2027 and 3.6% in 2028. The same text says long-term euro area yields have risen mainly through the real term premium, the extra return investors demand for holding longer-dated bonds. In other words, the driver of higher yields is not inflation expectations. It is the real compensation investors want for absorbing more government debt.

The mechanism linking these two facts is straightforward. Europe has removed defence spending of up to 1.5% of GDP a year from the reckoning of its fiscal rules, but it has not removed the need to finance that spending in the market. The discipline that the rule was meant to supply has moved from a procedure in Brussels to a price in the bond market: the real term premium on a deficit heading for 3.7% in 2027.

How the rule bent

In 2025 the EU activated the national escape clause for defence. The clause lets a member state deduct certain spending from its deficit calculation. According to Agence Europe, 17 countries are using it, and additional military spending of up to 1.5% of GDP a year can be kept outside the deficit count over 2025–2028. The Brussels Times reports that on 3 June 2026 the Commission added an energy security leg to the same clause. It is capped at 0.3% of GDP a year and 0.6% in total, and applies only to nationally funded measures decided after 28 February 2026.

The extension was not uncontested. Agence Europe reported on 21 September that Hasekamp, chair of the European Fiscal Board, warned the escape clause could turn into "a kind of ad hoc golden rule". A golden rule exempts investment spending from the deficit count. The board's annual report says 8 more member states asked for a slower adjustment path, and that Germany and Slovenia met the conditions for opening an excessive deficit procedure.

Germany's presence on that list is the key to the picture. Europe's least indebted large economy hit the EU procedure threshold the moment it loosened its own constitutional rule for defence in 2025. The two layers of the rulebook no longer balance each other. As one bends, the other is breached numerically.

Three capitals, three different constraints

Berlin opened the debt brake for defence. The 8 September draft cited by Grosswald puts 2027 federal spending at 555.4 billion euros and net borrowing at 118.7 billion. Of that borrowing, 85.4 billion euros comes under the exemption for defence and security spending above 1% of GDP; only 33.4 billion falls under the ordinary debt rule. The defence ministry budget rises by 27.1 billion euros to 109.7 billion. EU Today reports that, including the infrastructure fund and the Bundeswehr special fund, total borrowing reaches 203.6 billion euros.

Paris has to do the opposite. According to France 24, the government targets a deficit of 5.4% in 2026 and 5.0% in 2027, and plans a total effort of 54 billion euros, including 43 billion in new measures. Public debt hit a post-war record of 119% of GDP in the second quarter, and France will borrow a record 340 billion euros in 2027. A Dow Jones report carried by MarketScreener says the French 10-year yield rose 17 basis points to 4.923% on 7 October. The spread over Germany was 139 basis points, after nearing 159 the previous Friday.

Rome is caught between the two. A Reuters report carried by Investing.com says that in August Italy planned to use 1.5% of GDP, about 36 billion euros, of extra deficit room under the escape clause through 2028. In the new plan, additional defence spending falls from 0.9% to 0.6% of GDP, about 14 billion euros a year, while the 0.6% allowed for energy will be used in full. Italian debt will peak at about 139% of GDP in 2026, and the government aims to exit the excessive deficit procedure by mid-2027. Under market and procedural pressure, Italy has cut its defence pledge by a third.

Why it locked up now

When the escape clause was designed in 2025, policy rates were falling. Today the ECB rate stands at 2.50% after the second hike of the year in September, and the account says markets price a further 84 basis points of tightening by the end of 2027. In the Reuters poll, the number of economists expecting a 3.00% peak rose from 2 to 24 in a month. Defence debt is no longer financed with cheap money. It is financed with a rising policy rate and a rising term premium.

The cost is starting to reach the real economy. According to the ECB account, corporate lending rates rose to 3.8% and the cost of market-based corporate debt to 4.0%; mortgage rates held at 3.5%, and mortgage lending growth slowed to 3.0%. The other side of the Atlantic is lifting the floor as well. On 8 October the US Treasury sold 30-year bonds at a yield of 5.618%, with the bid-to-cover ratio falling to 2.54. Europe's defence debt is coming to market while the world's risk-free rate floor sits at 5.6%.

Growth is thinning the buffer too. Destatis data show German exports fell 0.8% month on month in August, against a 0.6% rise expected in a Reuters poll, and exports to the US dropped 6.3%. Factory orders released the day before had fallen 10.6%; RTÉ reports that military vehicles, aircraft, ships and trains drove the decline. German growth is increasingly tied to public orders, which leaves the denominator of the debt ratio weak.

The structure of the bond market has also changed. Speaking at the CBRT's Istanbul Economic Forum on 8 October, Bank of England Governor Bailey said bond markets had become more fragile, with leveraged investors replacing long-term real-money investors. A Reuters report carried by Investing.com says Bailey stressed that fiscal credibility is needed more than ever. A leveraged buyer exits fast on a budget surprise, which makes spread widening non-linear.

The channel into Türkiye

For Türkiye, the channel runs through trade more than through bonds. TÜİK data cited by CNBC-e show that Germany was Türkiye's largest export market in July at $2.042 billion. The UK ranked third at $1.349 billion and Italy fifth at $1.110 billion. Total exports that month were $25.623 billion. France's 43 billion euro package of measures and Italy's civilian spending squeeze directly depress consumer and public demand in these markets.

German defence spending may not fully offset that loss. As the defence budget rises to 109.7 billion euros, 55.8 billion is earmarked for military procurement. We found no sourced data on how much of that procurement reaches Turkish suppliers. Meanwhile the civilian-demand items in July's $2.042 billion of exports to Germany are directly exposed to the cuts in France and Italy and to the 0.8% fall in German exports. A higher term premium in Europe could also raise costs for Turkish companies borrowing in euros; no current, sourced data could be found on the size of that channel either.

What would break this reading

Our central scenario, at 50%, is that the rule keeps bending and the term premium becomes entrenched. The Commission accepts defence and energy requests, the France–Germany spread stays in a 130–160 basis point band, and the German 30-year yield holds above 3.7%. At 30%, the market imposes discipline: a budget accident in France or Italy pushes the spread above 160 basis points and governments cut defence top-ups further. At 20%, the energy shock fades, the ECB stops at 2.75% and the term premium retreats.

First falsifier: if the German 30-year yield falls from 3.84% on 8 October to below 3.50%, the term premium thesis weakens. Second falsifier: if the Commission opens an excessive deficit procedure for Germany and Berlin cuts spending, the rule has become binding again. Third falsifier: if TİM's October and November data show exports to Germany, Italy and France up more than 5% year on year, the Türkiye channel is limited.