What Germany’s fiscal shakeup means for markets

Meanwhile, the prospect of an unprecedented ramp-up in government debt issuance needed to fund the German fiscal package triggered a sell-off in German government bonds, which saw their largest weekly rise in yields since Germany’s reunification in 1990.¹

Here, we outline what is set to change as part of the proposed policy—and what this could mean for equity and bond markets.

The fiscal changes would mark a major shift in Germany’s historically conservative fiscal spending approach, which sets tight limits on federal borrowing levels, and would pave the way for the largest increase in fiscal spending by Europe’s largest economy in more than a generation.

The new fiscal package includes three significant changes: A new €500 billion infrastructure investment fund, an exemption from Germany’s “debt brake” rule on defense spending above 1% of GDP, and a rise in the net borrowing cap for federal states from 0% to 0.35% of GDP.

If implemented, the plan would unlock billions of euros in spending that could help kickstart Germany’s flagging economy, which has been contracting for more than two years.

Financing for the new plan would come from a significant increase in government-backed debt levels. German and European fixed income markets balked at the potentially huge rise in issuance of German government debt that would be needed to fuel the spending package, with the 10-year German bond yield ending the week of the announcement 43 basis points (bps) higher at 2.84%—its largest weekly yield increase in nearly 35 years.¹ This is despite an interest rate cut by the European Central Bank (ECB) on March 6, which lowered the bank’s deposit facility rate to 2.5%. (A basis point is one hundredth of a percentage point.)

While Germany’s announcement came too late to be incorporated into the ECB’s March staff forecasts, in its statement, the ECB cast a cautious tone, citing increased uncertainty and fiscal loosening as risks to the euro area’s economic outlook. In our view, this will likely lead to a more noncommittal tone around future rate moves by the ECB.

Uncertainties remain about the execution and timing of the fiscal plan, especially in relation to defense spending. However, if the plan proceeds, a reasonable base-case scenario would see the German fiscal deficit rise by 1.5% of GDP over the course of 2025 and 2026, implying a boost to euro area GDP of 0.4 to 0.5 percentage points by the end of 2026. Additionally, stronger growth would be consistent with the ECB reducing its planned rate cutting cycle by 1 to 2 cuts in 2025.

A key downside risk to these expectations is the prospect of significantly higher U.S. tariffs. Our calculations suggest that if the U.S. were to implement a 25% tariff on E.U. goods for an extended period, it could offset the expected gains from Germany’s expansionary fiscal policy in both 2025 and 2026.

The announcement signals a regime change in Germany, and we believe it’s a potential game-changer for Europe. As well as reviving growth from 2025 onward, it could well be a catalyst for European equity outperformance and bond underperformance.

For equity markets, the immediate rally we’ve seen in German and, more broadly, European, shares could become more sustained, especially once there is more certainty about implementation of the fiscal package. Higher trend growth is positive for German and European equities over the long term.

We anticipate that European bond markets will remain volatile while they digest the implications of such a significant increase in government debt entering the market and the potentially higher future borrowing costs over the longer term.