In our previous rates article, Fun and games in macro markets, we likened Europe’s current economic stance to the end of a gameshow. The contestant has just won a prize – now they face a choice: take what they’ve got or gamble it all for the star prize…with the risk of leaving with nothing but their bus-fare home.

The slick gameshow host turns to the crowd and asks them what the contestants should do…

…in Europe, the crowd roars “gamble!”

Germany is going for the star prize

This week, German Chancellor-elect Friedrich Merz announced significant changes to the country’s spending and investment plans. If approved, defence spending, amounting to 1% of GDP (approximately €80 billion), will be exempt from Germany’s self-imposed ‘debt brake’. This strategic shift aims to enhance conflict management capabilities while also freeing up fiscal space for other critical investments.

On top of this, Merz announced a substantial infrastructure spending package, committing €500 billion over the next 10 years. Germany aims to fix its crumbling infrastructure, including its once-envied rail system and deteriorating bridges.

Furthermore, the government will relax borrowing restrictions for German regions (Länder), allowing up to 0.35% of GDP borrowing per year. This marks a paradigm shift for Germany, which has suffered from lacklustre growth for years.

Germany is not alone

There appears to be widespread European support for such moves. The European Union (EU), under Ursula von der Leyen, has relaxed spending rules to accommodate increased defence budgets. For a body usually hampered by bureaucracy, the speed of change has been surprising – even if we are still some way from implementation.

Policymakers are also deploying central funding. The repurposing of Next Generation EU funds for defence and the potential for additional cross-Europe borrowing indicate a strong commitment to addressing geopolitical challenges.

So, Germany is not alone – but it is the first national mover. There will be significant pressure for other countries to follow suit, especially Italy and Spain, which are well behind the curve on defence spending. The relaxation of fiscal rules should make increased expenditure more politically palatable.

Significant spending might also help dampen President Trump’s ire. Much of the bearishness surrounding Europe’s economic outlook has been predicated on an already low growth forecast, further damaged by the expected first and second-order effects of US tariffs. Trump is clearly willing to strike deals, however. Meeting some of his demands for more spending might reduce the impact of tariffs. An agreement to exclude autos is already in the offing.

A word of warning – Germany’s ambitious plans hinge on continued political goodwill from the electorate and rival parties. Merz is treading an extremely fine line in trying to push these measures through the current parliament.

There is substantial execution risk. Spending the billions effectively in such short order will be no small task. The market is paying little heed to timelines.

The biggest daily bund move since 1990

All this might sound positive – but don’t forget, as bond investors, we’re naturally pessimistic. Europe will fund most of the planned additional spending by issuing bonds. French President Macron recently expressed his desire for more defence spending, but without committing to further taxation. This requires more borrowing.

The huge volume of planned additional issuance has materially raised German bund yields. Wednesday’s increase was the largest daily move since German reunification in 1990. This is more impressive than concerning – we’re simply seeing the clearing level for bunds rising to a new level.

Yield curves should steepen, at least from tenors 10 years and out, which are less affected by monetary policy. Higher growth and inflation potential, combined with greater issuance, will lead investors to demand higher term premia. We’re among those favouring European curve steepeners.

Front-end yields look at risk. As the growth outlook becomes less negative, the European Central Bank (ECB) may see less need to lower rates. Even if the implementation of spending plans is far off, the prospect is likely to weigh on the monetary policy outlook. The latest ECB meeting confirmed deep uncertainty for policy setters.

And there’s another elephant in the room – timelines. Europe may have positively surprised with the speed of its response, but spending the committed billions will take time. We expect markets to deliberate at length on whether the promise of ‘jam tomorrow’ is sufficient to generate positive spillovers for real economies, and if the multipliers from spending are meaningful.

How united is Europe really?

Extremely – for now. On the positive side, recent weeks have demonstrated a marked uptick in European integration, supported by central and national leaders. Growth is back on the agenda, led by a previously reluctant Germany. In the hope that we have improved prospects for peace, sentiment should grow more positive, and the risk of higher energy prices across Europe can reduce.

However, massively increased spending has already shown that it can push yields significantly higher. Country spreads may have modestly tightened in the process, but for nations with uncomfortably high debt-to-GDP figures, yields rising by 0.75% or more will be troubling.

The EU-sanctioned nature of additional borrowing eases concerns to some extent. Nonetheless, it’s hard to ignore the absolute value of the outstanding debt and markedly higher yields. For now, the market is looking through this – but expect some challenging conversations ahead.

European yields can still rise

Germany's fiscal shift represents a new era for Europe. Increased spending on defence and infrastructure can boost economic growth and stability, addressing both short-term and long-term challenges.

That said, the market has a lot to digest. The balance between growth and fiscal responsibility will be crucial. Much still hangs on political agreements, and unwieldy coalitions are pervasive across Europe. Donald Trump’s daily policy changes make planning yet more challenging.

A few weeks ago, we wrote that European yields can rise. Even after this week’s meteoric moves, we still see further yield upside.