Germany's Fiscal Shift: Market Implications and Global Ripples

The tone of the Trump administration towards Europe has gone far beyond tough love to “self-help”, and Germany at least seems to have finally gotten the message. We believe the potential loosening of Germany's debt brake signals a significant shift – not only for Germany but for Eurozone fiscal policy more broadly. In this blog, we analyze the market reaction and potential ramifications, both over the short and long term.

What’s been proposed

Friedrich Merz, leader of Germany’s Christian Democratic Union (CDU) and widely tapped to be the country’s next chancellor, announced late Tuesday (March 4) he had reached a deal with the rival party Social Democrats (SPD) to loosen stringent budget rules. The looser rules would allow increased defense spending and set up a €500bn off-balance sheet vehicle for debt-funded infrastructure investment. Regarding the former, the new defense proposal recommends that "necessary defense spending" above 1% of GDP should be exempt from debt brake restrictions, with no upper limit.

How has the market reacted?

This announcement has come when the tide of sentiment seems to have just started to turn in Europe; energy prices (Europe’s Achilles Heel) have been falling, and equity markets rallying, adding fuel to the fire. Equity and bond markets reacted significantly the day after the deal was announced:

• Eurozone Bond Markets
  
  Wednesday (March 5) saw a sharp uptick in German government bond yields with the 10-year jumping almost 30 basis points (bps), and the curve (2y-10y) steepening 9 bps. This move was closely mirrored across other Eurozone government bond markets. We believe this momentum (higher long-term yields steepening curves) is likely to continue as markets price in the effects of increased debt issuance in Germany in particular, but across the Eurozone more broadly, factoring in their possible effects on long-term growth and inflation.
  

• Equity Markets:
  
  European equities, particularly in sectors related to infrastructure, construction, and defense, as well as financials, have rallied strongly on expectations of increased spending and the commensurate need for financing. In particular, the Stoxx Europe total market Aerospace and Defense sector jumped over 12% on the day, taking its YTD gains to over 34%, slightly besting the Eurozone Bank Index’s gain of close to 30% on the year. In contrast, the S&P 500 Aerospace and Defense Index is up just over 5.5% YTD. We anticipate continued sector-specific rallies in European equities, with companies poised to benefit from public investment seeing the most significant gains. In addition, we could see “assists” to sectors which are related to the primary beneficiaries and would benefit from the related capital investment and easing of supply chain pressures (for example, automobiles and chemicals).
  
  
• Currency Markets
  
  The Euro has strengthened by over 1% for the third day in a row versus the US Dollar, for its biggest three-day gain (almost 4%) since 2015, reflecting investor confidence that this boost to spending will primarily benefit European companies and economies. Arguably this view on Europe has continued rebounding from extreme pessimism (see our 2025 Global Market Outlook), and this renewed optimism has been expressed in the currency markets. But this FX trend is one that we see running out of steam in the near term, given the still-looming tariff risk from the US, weaker European growth, and easing bias from the European Central Bank all weighing on the euro (see Tariff Risk Looms Large).

While it is still early days, this news reinforces the unexpected turnaround in the European outlook since the start of 2025. Markets were largely pricing a continuation of sluggish recovery and slow growth heading into this year and were surprised by a sharp rebound in European stocks, which have outpaced US stocks YTD. Fiscal worries have been replaced by newfound optimism. The scale of the transformation in Germany’s debt market is huge, and markets will closely monitor Germany's debt trajectory and its ability to maintain fiscal discipline. As we wrote in France’s Fiscal Fragility Strains the Eurozone, if this fiscal expansion in Germany can lead to growth, firstly in Germany, but then rippling through the Eurozone, it could be the key for more fragile countries like France to be able to grow their way out of their fiscal burden. (A European rebound was also one of our recent Grey Swans. While we were not confident it could happen, we are happy our hunch turned out to be right.)

Germany's fiscal shift could influence fiscal policy in other Eurozone countries, potentially leading to a broader loosening of fiscal constraints. This increased government spending could contribute to inflationary pressures, which could lead to a more hawkish shift in the European Central Bank's monetary policy, which in turn could provide a bullish counterpoint to our argument against the euro.

Whether the market reaction to Germany’s announcement is a “flash in the pan” or can be sustained depends in large part on the machinery of politics. Geopolitical risks and global economic uncertainties will continue to play a significant role in shaping market outcomes.

As always, we are closely monitoring these developments and adjusting our investment strategies accordingly.