German Fiscal Bazooka Sends Euro, Bund Yields Surging

Germany’s incoming chancellor has announced spending plans that break with the nation’s long-held doctrine of low borrowing, igniting a bond market selloff but lifting stocks and the euro.

The euro surged to $1.07, its highest level since early November. The move has had its greatest impact on German sovereign bonds (Bunds), whose yields spiked above 2.7%—their highest level in nearly three years.

“The fiscal sea change will permanently alter how Bunds are trading,” said T. Rowe Price chief European economist Tomasz Wieladek Wednesday morning. “Bunds will likely sell off significantly today and start trading more like other safe-haven bond markets out there in the future.”

The plans were announced by election winner Friedrich Merz’s conservative Christian Democratic Union and his prospective junior coalition partners. The parties also agreed to reform the nation’s constitutional borrowing limit, colloquially called the “debt brake.” Such a step would need to be taken before March 25, while the current parliament (based on the 2021 election) is still in place, as anti-establishment parties won a blocking minority in February’s vote.

In a joint press conference Tuesday night, conservatives and social democrats signaled that the parliament could convene as soon as next week to vote on the proposals.

How Will Germany’s Debt Brake Change?

Tuesday night’s proposals consist of a EUR 500 billion infrastructure package that circumvents the debt brake, akin to 2022’s EUR 100 billion special defense budget. Defense spending is to be unfettered by exempting all expenditures above 1% of GDP from the debt brake—which amounts to removing all constraints, as defense spending already exceeds this level. Finally, the debt brake will no longer force Germany’s federal states to keep balanced books, permitting deficit spending at the state level.

Combined with the European Union’s proposed exemption of military spending from the bloc’s fiscal stability rules by activating an escape clause meant for times of crisis, these changes open the door to a drastic increase in defense spending.

“The announcement surprised the market, particularly regarding the defense sector, where expectations were for a fund similar to that for investments, rather than a general indication of the lower limit of potential spending,” says AllianzGI fixed income portfolio manager Monica Zani. “These decisions translate into at least an additional EUR 1 trillion in spending over ten years, which is just under 25% of Germany’s GDP.”

A 180-Degree Turn for Germany’s Fiscal Hawk

With this move, Merz has abruptly changed his long-held position that Germany’s debt brake was fit for purpose and needed to remain. He said Tuesday that Germany must do “whatever it takes” to bolster its ability to defend itself, echoing then-ECB head Mario Draghi’s 2012 speech announcing an aggressively expansionary monetary policy to preserve the euro.

Within Merz’s party, the plans remain highly controversial. “It doesn’t get much worse than this,” German daily Handelsblatt cited members of the CDU’s fiscally conservative faction saying on Wednesday, after the party ruled out special one-off budgets that skirt the debt brake in its electoral platform.

“All of this feels like a huge leap that the CDU/CSU appears to have made,” JPMorgan researcher Greg Fuzesi wrote Tuesday night. “Only yesterday, Merz still said that a large Special Fund actually increased the pressure to consolidate the rest of the budget.”

Effects on Sovereign Debt Beyond Germany

Due to the Bund’s status as the risk-free benchmark for the cost of raising debt across the region, Germany’s fiscal policy reset is having a knock-on effect on euro-area government bonds. Yields are expected to rise as well, creating pressure for other European governments to curtail borrowing in the longer term.

The spread between the Italian BTP and the Bund was down about 2.5% to 105 basis points (the tightest since October 2021), as Italian 10-year bond yields rose to 3.7%, less sharply than the Bund. The spread between the French OAT and the Bund declined to 71 basis points as OAT yields rose to 3.4%. The spread between the Spanish Bono and the Bund fell 4% to 66 basis points, according to Teleborsa.

Construction Stocks Lead Equity Rally

The prospect of a new era of fiscal leniency also boosted European stocks on Wednesday. Germany’s DAX benchmark jumped 3.2%, and the regional Stoxx Europe 600 index was up 1.6% by midday, led higher by construction stocks that included Kion KGX (up 17.6%), Wienerberger WIE (up 16.3%), and Hochtief HOT (up 15.2%).

European banks also rallied, with Deutsche Bank DBK and Commerzbank CBK each up about 9.0%, Italy’s UniCredit UCG up 5.2%, and BNP Paribas BNP up 4.0%. Beyond the Eurozone, Barclays BARC traded 4% higher and Switzerland’s UBS UBS was up 3.1%, though there is no obvious causal link with Germany’s moves.

“Today’s rally in the European banking sector has effectively recouped yesterday’s sharp losses [on tariff fears],” Morningstar analyst Johann Scholtz says. “We are somewhat surprised by the swift reversal, given that the tariff narrative remains unchanged. We think European banks, often seen as a bellwether for the broader economy, may continue to experience heightened volatility amid ongoing geopolitical uncertainties.”

Defense Stocks Extend Rally

The region’s aerospace and defense stocks continued a dramatic rally that started with double-digit gains on Monday. Germany’s Rheinmetall RHM and Italian peer Leonardo LDO each gained about 4.0%, France’s Thales HO jumped 6.7%, Dassault Aviation AM rose 4.4%, and Sweden’s Saab SAAB B traded about 6.0% higher.

Smaller defense stocks also rallied further, with German sensors specialist Hensoldt HAG up 7.0% and Norwegian missile and electronics group Kongsberg KOG trading 3.5% higher.

Sara Silano and Jocelyn Jovene contributed to this story.