- A seismic fiscal shift has been announced by Germany’s Chancellor in waiting.
- This has sent yields surging across Europe at a rapid speed.
- German shares are soaring and are boosting the European equity space.
- EUR/USD may target $1.10.
- Could the ECB cut interest rates at a slower pace than the Fed in 2025?
There is a major shift going on in Europe’s bond market. Yields are surging on Wednesday, the German 10-year yield is higher by nearly 20 bps and French 10 year yields are higher by 14bps. This is not the sign of a new sovereign crisis, but instead comes after the new German leader, Friedreich Merz, said that he would amend the German constitution to ensure defense spending was exempt from German fiscal rules. This could unlock a tidal wave of German and other European borrowing this year to fund the strengthening of Europe’s defense forces.
The future German chancellor did not stop there. He also announced a EUR 500bn infrastructure fund that will prioritize transport, energy and housing projects over the next 10 years. This is huge. For years, economists have said that Germany needed to change its spending rules to get out of the economic hole. It’s taken a Conservative Chancellor-in-waiting to pull the trigger.
This is Merz’s ‘Draghi moment’. He said Germany would ‘do whatever it takes’ to defend itself, and, we could argue, to do whatever it takes to spend its way out of economic malaise.
The euro is back
The financial market impact has been immediate and immense. The scale of the move in European bond yields this morning is historical, this is rapidly boosting the euro. EUR/USD has jumped nearly 2% in 2 days, it is back above $1.0670, and its march higher is continuing this morning. $1.0722 is the 200-day sma for EUR/USD, a break above this level would be a further bullish development for the euro.
Merz and Trump: one boosts growth, the other weighs on growth
The contrasting stance between Merz and Trump could not be more stark today: Merz is expanding Germany’s economy and taking responsibility for the security of the region, the US economy is under threat from tariffs and stagflation at the same time as the US becomes a less reliable partner to the western world. The strong recovery in the euro suggests that Europe’s star is rising, as the USD continues to lose its luster as the ‘Trump Bump’ comes to an end.
From a technical perspective, $1.10 is the most logical resistance zone for EUR/USD right now. The FX market is following the stock market, where European stocks have been outperforming US stocks since the start of the year. Europe is back, and Germany is once more its de facto leader.
The surge in longer term bond yields has also put upward pressure on short term yields, 2 year yields are higher by more than 5bps across Europe, so far on Tuesday. There is a risk that Germany and Europe are funding defense spending with expensive borrowing, which could erode the finances of European nations. If bond yields continue to rise, then this can’t be ignored. However, we think that today’s bond market readjustment is caused by the improving growth outlook for the currency bloc.
ECB vs. the Fed: Germany’s fiscal shift could reduce ECB rate cut hopes
As bond yields and the euro have surged, ECB rate cuts have been scaled back. There is now a 54% chance of a rate cut in April, down from 66% at the start of the week. Prospects for a May cut have also fallen this week, which suggests that there is some uncertainty around the number of cuts expected this year. The ECB meets on Thursday, and we will also get their latest economic projections. Will these projections include Germany’s spending pledges? If not, then they are mostly useless for traders, if yes, then things could get interesting. If the ECB Staff think that higher spending on German infrastructure and defense will be inflationary, then we could see expectations of ECB rate cuts get scaled back, at the same time as expectations for Fed rate cuts are boosted.
We could be in a situation where the Fed cuts by more than the ECB this year. This would be major readjustment in central banking expectations, and it could also signal a stronger Europe vs. the US, after years of US exceptionalism.
European stocks surge as Germany loosens the purse strings
European stocks have also bounced back after getting pummeled on Tuesday. They are surging across the board, but Germany is leading the way. Defense stocks along with industrials and manufacturing stocks are helping the Dax, which is higher by more than 2% on Wednesday. The mid-cap MDax is also outperforming the blue chip index, which suggests that the market sees Germany’s seismic fiscal shift as renewing the German economy.
What’s good for Germany is positive for the rest of Europe. European stocks are a sea of green today. This also suggests that the bond market readjustment is not spooking investors and it is instead a reaction to enhanced growth prospects for the region.
It is worth noting that Germany will be issuing debt into a plunging bond market, but that is a problem for another day. For now, the euro is the best performing currency in the G10 FX space this week, the Dax is continuing to dominate the equity market, and rising bond yields suggest a transformed economic outlook. Germany is back.
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