Germany’s incoming chancellor has announced spending plans that break with the nation’s long-held doctrine of low borrowing, igniting debt markets while boosting equities and the euro.
The euro surged to $1.07, its highest level since early November, though the move has had its greatest impact on German sovereign bonds (Bunds), whose yields spiked to above 2.7%, its highest level in nearly three years.
“The fiscal sea change will permanently alter the way that Bunds are trading,” T. Rowe Price chief European economist Tomasz Wieladek said on Wednesday morning. “Bunds will likely selloff 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 CDU and his prospective junior coalition partners before even taking office. 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 on Tuesday night, Conservatives and Social Democrats signaled that the country’s 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 500 billion euro infrastructure package that circumvents the debt brake, akin to 2022’s 100 billion euro special defense budget. Defense spending is to be unfettered by exempting all expenditures above 1% of GDP from the debt brake—which amounts to a removal of 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.
A 180-Degree Turn for Germany’s Fiscal Hawk
With this move, Merz has abruptly changed tack on his long-held position that Germany’s debt brake was fit for purpose and needed to remain in place. He said on Tuesday that Germany’s ability to defend itself must be bolstered by doing “whatever it takes,” echoing then-ECB head Mario Draghi’s 2012 speech announcing aggressively expansionary monetary policy to preserve the euro.
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, where 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 it has been since October 2021, as Italian 10-years bond yields rose to 3.7%, less sharply than Germany’s Bund.
The spread between the French OAT and the Bund also declined to 71bp as OAT yields rose to 3.4% while the spread between Spanish Bono and the Bund fell 4% to 66bp, 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 mid-day, led higher by construction stocks including 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%, Italy’s UniCredit UCG up 5.2% and BNP Paribas BNP up 4%. 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 political moves.
“Today’s rally in the European banking sector has effectively recouped yesterday’s sharp losses” on tariff fears, Morningstar analyst Johann Scholtz said. “We are somewhat surprised by the swift reversal, given that the tariff narrative remains unchanged. We think that 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% while France’s Thales HO jumped 6.7% and Dassault Aviation AM rose 4.4% and Sweden’s SAAB SAAB B traded about 6% higher.
Smaller defense stocks also rallied further, with German sensors specialist Hensoldt HAG up 7% and Norwegian missile and electronics group Kongsberg KOG traded 3.5% higher.
Sara Silano contributed to this story.
The author or authors do not own shares in any securities mentioned in this article. Find out about Morningstar’s editorial policies.
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