Europe’s economy

Germany’s conservative leader Friedrich Merz, set to become the next chancellor, sealed a landmark deal on Friday with the Greens and Social Democrats to ease Germany’s strict borrowing limits, unlocking an unprecedented €500-billion spending spree that could redefine the country’s economic future.

Markets have responded swiftly, sending the euro higher and German equities surging as investors bet on an economic boost from increased defence and infrastructure spending.

The new agreement will exempt defence spending beyond 1% of GDP from Germany’s strict constitutional debt brake and create a €500bn fund for infrastructure investment. It also includes €100bn earmarked for climate and economic transformation projects.

“Germany is back,” said Merz, announcing the deal

“It is a clear message to our partners and friends, but also to our opponents, to the enemies of our freedom: we are capable of defending ourselves and we are now fully prepared to defend ourselves,” he added.

Merz expects the necessary constitutional amendments to be voted on as early as Tuesday. With a two-thirds majority needed to approve the changes, negotiations with the Greens proved crucial in securing support.

Market optimism and economic forecast upgrades

Markets have embraced the shift in Germany’s fiscal stance. The euro climbed 0.3% to 1.0890, heading for a second straight week of gains, while the yield on Germany’s 10-year Bund rose six basis points to 2.90%

The DAX index jumped 1.5%, with defence and industrial stocks leading gains

Rheinmetall soared 8.76%, HeidelbergCement gained 5.19%, and Siemens Energy rose 3.18%. Financials also rallied, with Commerzbank up 3.54%

Broader European markets followed suit, with the Euro STOXX 50 rising 1%, Italy’s FTSE MIB up 1.8%, and France’s CAC 40 climbing 1.2%.

The banking sector was another standout performer, with Erste Bank up 4.88%, Deutsche Bank gaining 3.59%, and BNP Paribas rising 3.47%

“Markets are clearly viewing the change in Germany’s fiscal stance as comparable to the decision to jointly issue debt in response to the pandemic,” said Bank of America analyst Adarsh Sinha.

Goldman Sachs has significantly revised its German growth forecasts, now predicting GDP will rise by 0.2 percentage points to 0.2% in 2025, by 0.5 points to 1.5% in 2026, and by 0.6 points to 2% in 2027. The investment bank also sees a broader spillover effect across Europe, lifting eurozone GDP growth projections to 0.8% in 2025, 1.3% in 2026, and 1.6% in 2027.

“The fiscal news lowers the pressure for the ECB to reduce rates below neutral. We therefore no longer expect the Governing Council to cut at the July meeting and raise our forecast for the terminal rate to 2% in June,” said Goldman Sachs economist Sven Jari Stehn.

?ECB rate hike risks to emerge

While Germany’s fiscal expansion has been welcomed by investors, some policymakers are concerned about its inflationary impact.

European Central Bank (ECB) Governing Council member Robert Holzmann, one of the most hawkish voices in Frankfurt, said higher government spending could force the ECB to reverse course on rate cuts and even start raising rates again.

“We don’t yet know what will happen. However, if that happens, the direction for interest rates points toward neutral to rising, rather than neutral to falling,” Holzmann told Germany’s Platow Brief.

?A new era for Europe’s economy

The German fiscal expansion marks a turning point not only for Berlin but for the entire eurozone.

Sir Alex Younger, former chief of Britain’s Secret Intelligence Service, highlighted the significance of the shift.

“Germany’s recent decision to throw away the fiscal orthodoxy of the last three decades and sharply increase defence and infrastructure spending was a step in this direction; Europe doesn’t change unless Germany does, so this is huge,” Younger said in an interview with Goldman Sachs.