European financial markets have rallied sharply and German borrowing costs have soared after the country’s prospective leaders announced a historic deal to loosen its “debt brake” rule to boost spending on defence.
The yield – in effect the interest rate – on 30-year German government bonds rose by 16 basis points, after having earlier jumped by as much as 25 basis points to 3.07% in its biggest increase since October 1998.
The Dax 30 index, which tracks the largest German companies, rose by almost 4%, powered by industrial stocks. Share prices also leapt in London, Paris and Milan amid investor hopes that a massive boost in European spending on defence and infrastructure would kickstart the region’s ailing economy.
Defence stocks have gained sharply in recent weeks as world leaders scramble to piece together the funding for a vast increase in military expenditure amid mounting concern over Donald Trump’s commitment to European security.
The EU outlined a plan on Tuesday to unlock almost €800bn (£670bn) for defence spending, while the UK government said last week it would raise its spending from 2.3% of GDP to 2.5% by 2027, two years earlier than planned, worth an additional £6bn a year.
Shares in Rheinmetall, the German automotive and arms manufacturer, rose by 5% on Wednesday and have rocketed by 94% this year. Britain’s BAE Systems has rallied by 40% so far this year, Italy’s Leonardo is up 74% and Paris-listed Thales has risen by 77%.
The euro rose by 0.7% against the US dollar to about €1.07. The pound also gained against the dollar on a day of dramatic moves in markets, as investors also reacted to the US commerce secretary, Howard Lutnick, suggesting a deal could “probably” be reached to de-escalate Trump’s trade war with Canada and Mexico.
Some analysts said there was a danger of the dollar losing its “safe-haven” status among global investors as Trump’s trade wars rattle the world’s largest economy. “The speed and scale of global shifts is so rapid that this needs to be acknowledged as a possibility,” said George Saravelos, global head of currency research at Deutsche Bank.
In a sea change for economic policy after years of sticking to tough rules on government debt, Germany’s chancellor-in-waiting, Friedrich Merz, said on Tuesday that defence spending above 1% of GDP would be exempt from the country’s debt rule.
Agreed with the centre-left Social Democrats, who are expected to form a coalition with Merz’s Christian Democratic Union (CDU), the plan also includes the creation of a €500bn fund to finance spending on Germany’s infrastructure over the next 10 years.
In response, Germany’s biggest construction and engineering companies posted sharp share gains on Wednesday. Cement maker Heidelberg Materials jumped by 13.5%, industrial services firm Bilfinger leapt by more than 19% and construction group Hochtief advanced by 15.4%. Engineering and steel firm ThyssenKrupp rose by 13.6%.
Echoing the words of Mario Draghi, the former European Central Bank president during the eurozone debt crisis, Merz said Germany would do “whatever it takes” on defence. Under pressure to raise spending on defence from 2.1% of GDP last year, analysts at Morgan Stanley said the overall size of the German plan could reach more than €1tn.
Holger Schmieding, chief economist at Berenberg Bank, said the plan amounted to a “really big bazooka” with potential to transform Europe’s largest economy. “They are a fiscal sea change for Germany,” he said.
“The extra room for defence spending sends a clear signal to Vladimir Putin and Donald Trump as well as to Germany’s European friends that Germany is serious about defending itself and helping Ukraine.”
Described as “one of the most historic paradigm shifts in German postwar history” by economists at Deutsche Bank, the deal will effectively sideline the constitutional debt brake, or schuldenbremse, for spending on defence.
Introduced in 2009 by Angela Merkel after the financial crisis, the rule, often restricting annual federal borrowing to 0.35% of GDP had been symbolic of Germany’s strict approach to tax and spending policy.
City analysts said sidelining the rule would be a gamechanger for the country’s economy amid big challenges from collapsing industrial output; weakened by slack demand and competition from Chinese electric vehicle manufacturers.
“Germany was facing a potential growth trajectory heading towards zero over coming years. [The defence and infrastructure boost] catapults growth prospects closer to 1.5-2% for 2027 onwards,” analysts at Bank of America wrote in a note to clients.
The debt-fuelled stimulus package comes with a cost, reflected in a rise in 10-year bond yields to almost 2.7%. However, German borrowing costs still remain significantly lower than in the US and the UK, where yields have reached more than 4%.