Germany’s spending bazooka propels euro and borrowing costs higher

FRANKFURT — Germany’s historic turnaround on public spending has sent shockwaves through financial markets, sending the euro and government borrowing costs sharply higher.

The euro shook off its usual fears about economic stagnation and Europe’s strategic vulnerability to surge against the dollar in early trading on Wednesday, while the German government’s 10-year borrowing costs leaped by nearly a quarter of a percent to their highest in 17 months, as investors raced to factor in the game-changing impact of hundreds of billions of euros in spending on defense and infrastructure projects. 

The moves are a reaction to the announcement late on Tuesday that Germany’s chancellor-in-waiting Friedrich Merz had struck a deal with his prospective coalition partners the Social Democrats (SPD) to effectively bypass a constitutional cap on the budget deficit. That news came on the same day that European Commission President Ursula von der Leyen proposed raising hundreds of billions more to restore Europe’s defense capacity.

“Europe and Germany in particular are showing a historically unprecedented responsiveness to revising the fiscal stance,” said George Saravelos, head of global FX strategy at Deutsche Bank.  

Prospects of a fiscal "bazooka" pushed the single currency up 0.7 percent against the dollar to 1.0722, the highest since November. Saravelos expects the rally to continue until at least the euro hits 1.10. And while not everyone is that enthusiastic, analysts have quickly dropped predictions that Europe’s weak economic outlook could push the euro down to parity with the greenback this year.

Merz’s plans, which will largely exempt defense spending from the so-called debt brake and also include a €500 billion special fund for infrastructure spending over the next 10 years, still have to pass parliament later this month. To this end, Merz and outgoing Chancellor Olaf Scholz will still have to win over the Greens, which is widely expected to happen.

Whatever it takes

“In view of the threats to our freedom and peace on our continent, ‘whatever it takes’ must now also apply to our defense,” Merz said on Tuesday, reviving the phrase of then-European Central Bank President Mario Draghi that proved to be the turning point in Europe’s sovereign debt crisis a decade ago.

Tuesday’s deal signaled a radical departure from the obsession with debt sustainability that has characterized German policy since the global financial crisis — and arguably before then. While economists still want to see its small print, they’re in no doubt of its transformative potential.

“Pending more clarity on this issue, and being mindful of some execution risk, we believe this is one of the most historic paradigm shifts in German postwar history,” said Robin Winkler, chief economist at Deutsche Bank Research.

Berenberg Chief Economist Holger Schmieding welcomed that “Germany is finally taking on the leadership role” and expressed hope that the new government will find the courage to enact the pro-growth supply-side reforms at the same time, to boost private as well as public investment.

“The can-do attitude shown tonight could lift sentiment and pull in private investment, even before fiscal policy gets going,” added J.P. Morgan economist Greg Fuzesi, who said he expects a “material change” to Germany’s economic outlook after two straight years of recession.

No free lunch

Other things being equal, said Barclays economist Balduin Bippus, the move should reverse the downward pressure that German fiscal policy has put on the euro since 2009, when Angela Merkel introduced the debt brake. However, he added with an eye on the looming trade war with the United States,“what complicates things is that at present all else is not equal — in a rather extreme way.”

The imposition of import tariffs by the U.S., and the effect that this may have on the U.S. economy, works “at cross purposes” with the German news, making it harder to say how much higher the euro can go, Bippus said.

What is clear is that the brave new world of fiscal largesse will also have a cost. Germany’s borrowing cost surged following the announcement with the yield on the 10-year note rising more than 20 basis points to above 2.7 percent, marking the biggest jump since June 2022. That had the knock-on effect of pulling borrowing costs for all eurozone governments up in parallel. German 30-year yields were on course for their biggest one-day rise since the late 1990s.

To some, that’s an alarming reminder of why the debt brake was there in the first place. Friedrich Heinemann, an economist with the ZEW think tank in Mannheim, warned that the reform is going too far and risks debt levels spiraling out of control. He noted that, in total, the Christian Democratic Union/SPD deal would allow Germany to finance 4 percent of gross domestic product in debt at any time. “This would quickly put Germany among the highly indebted countries of the EU, and the debt-to-GDP ratio will reach 100 percent as early as 2034,” Heinemann warned.

“Today is the day when the debt brake will become history,” lamented Lars Feld, an adviser to former Finance Minister Christian Lindner, whose opposition to looser fiscal policy sparked the collapse of the last federal government.

“Germany will lose its function as a safe haven for bondholders,” Feld said. “Interest rates and inflation will not remain unaffected.”