(Bloomberg) -- Germany’s historic plan to ramp up spending shook European markets on Wednesday, powering equities past their US peers, reviving the euro from the brink of parity with the dollar and consigning German bunds to their worst day since 1990.
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Investors hailed a landmark moment in Europe’s largest economy and traditional advocate of tight budgets after Chancellor-in-waiting Friedrich Merz declared Germany would do “whatever it takes” to defend itself and pledged to ease constraints on government spending.
Germany’s benchmark stock index surged 3.4% in its biggest one-day rally since 2022 and lifted the pan-European Stoxx 600 to near a record. Yields on benchmark 10-year bunds soared 30 basis points, the most since investors were preparing for German reunification following the collapse of the Berlin Wall. And traders bet on hefty gains for the euro just weeks after it was flirting with trading one-to-one against the dollar.
“What we’re seeing from Germany warrants a rewriting of the European investment playbook,” said Laura Cooper, head of macro credit and global investment strategist at Nuveen. “Markets are potentially underpricing the scale of what we are going to see come through on the fiscal front.”
Nuveen now sees yields on 10-year bunds rising to 3% by the middle of the year, compared to 2.2% ahead of the announcement.
Germany’s new strategy, unlocking hundreds of billions of euros for transportation, energy and housing, is a dramatic shift that upends Germany’s controls on government borrowing. It invokes memories of former European Central Bank chief Mario Draghi’s 2012 speech to save the euro, which became a shorthand for policy determination.
Germany is also calling on the European Union to reform its fiscal rules, according to people familiar with the talks. Europe’s largest economy is reportedly looking for the EU to allow countries bigger defense spending without running afoul of the bloc’s budget rules, given the geopolitical circumstances. EU leaders are expected to discuss possible changes to the fiscal rules when they meet on Thursday.
“Big, bold, unexpected — a game changer for the outlook,” Evelyn Herrmann, Europe economist at Bank of America Corp., said of Germany’s announcment. It represents a “paradigm shift.”
Deutsche Bank AG strategist Maximilian Uleer — a long-standing bullish voice on European stocks — said the region was facing its own “Make Europe Great Again” moment — a play on US President Donald Trump’s campaign slogan for America.
Uleer reiterated his overweight stance on European stocks overall, calling the German proposal “above even our positive expectations.”
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“When a nation knows it’s about to lose its key security guarantee, it concentrates the mind wonderfully. Germany has thrown off its self-imposed straitjacket of fiscal rectitude, and is planning to embrace borrowing on a scale it has not attempted to do so before.”
— Simon White, MLIVE macro strategist
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Stocks geared toward the German economy jumped, with the country’s mid-cap MDAX Index surging 6.2% — the most since March 2022. Construction firms such as Bilfinger SE and Hochtief AG were among the biggest gainers, advancing 18% and 16%, respectively. Defense companies like Rheinmetall AG added to a stellar rally this year, while heavyweights Deutsche Bank and Siemens AG were both up over 8%.
“There’s a very strong dynamic in Germany,” said Frederic Surry, deputy head of equities at BNP Paribas Asset Management, who has reduced his overweight on the US in favor of Europe. “We’re looking at a broadening, notably on mid-caps.”
European stocks have been among the best performers in the world this year, as investors bet on stimulus and a potential ceasefire in Ukraine. Cheaper valuations have also proved attractive at a time when funds are exiting pricey US equities, overshadowing concerns around a global trade war for now.
The benchmark Stoxx 600 is on course to outperform the S&P 500 by the most in a decade on a quarterly basis. Eight of the top 10 best performing stocks this year in the MSCI World Index — the benchmark for the developed world — are now European, data compiled by Bloomberg show. They include defense companies Rheinmetall, Thales SA, Leonardo SpA and Saab AB.
For the bond market, the prospect of more government spending in Europe raised alarm bells.
Yields on 10-year German bonds surged as much as 31 basis points to 2.80%. Germany’s borrowing costs are still the lowest in the region given its historic limits on spending. Investors also dumped other European bonds, driving up yields in Italy, France and the UK — all of which have faced market worries about fiscal spending in recent years.
Extra fiscal spending may mean less need for monetary policy stimulus. Traders pared bets on ECB interest-rate cuts to around 67 basis points by the year-end, down from as much as 90 basis points at the start of the week.
“There has been a big amount of fiscal concern in the US, UK and emerging markets but that hasn’t been true in Europe until now,” said Gabriele Foa, portfolio manager at Algebris Investments. “This big certainty that the market has regarding ECB cuts may be challenged too.”
The euro climbed over 1% to its strongest level since November at over $1.07. Just a month ago, the common currency was a whisker away from parity with the dollar, trading around $1.02.
This shifting dynamic could potentially reverse a multi-year US dollar rally, according to Julian Weiss, head of global Group-of-10 vanilla FX options trading at Bank of America.
Banks including Goldman Sachs Group Inc. have been abandoning predictions that the euro will slide to be worth the same as one greenback. Instead, some hedge funds are now buying options wagering the euro will climb another 12% to $1.20 in six to nine months, according to traders familiar with the transactions.
“This is Merz’s ‘Draghi moment’,” said Kathleen Brooks, research director at XTB. “The strong recovery in the euro suggests that Europe’s star is rising.”
--With assistance from Michael Msika, Julien Ponthus, Blaise Robinson, Vassilis Karamanis and Greg Ritchie.
(Updates with closing prices. An earlier version corrected third paragraph to remove reference to yields.)
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