(Bloomberg) -- Germany’s highest-stakes election in years is paving the way for a pivot to increased spending, with markets predicting the end of an era for constrained fiscal policy.
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The euro will be in focus when traders return to their desks from 5 a.m. in Sydney on Monday, just an hour after polls close. The currency has so far largely shrugged off the potentially far-reaching consequences of the vote, prompting fears about complacency in the event of an unclear or shock result; another risk is a better-than-forecast performance for the far right. Bond and stock futures begin trading at 1 a.m. in Berlin.
With no party expected to win a clear majority, investors are counting on the center-right CDU/CSU alliance — led by Friedrich Merz — to come out on top and form a strong coalition with one or two other mainstream parties. Such an outcome would likely ease the path toward reforms that could reboot Germany’s moribund economy — and enable changes to a constitutional limit on borrowing, introduced in 2009 and known as the debt brake.
That would mark a seachange for Germany, which has long preached fiscal prudence. But with the US pushing Europe to spend more on defense, such a shift is now on the table.
These are the “most meaningful elections this year,” Kim Catechis, an investment strategist for the Franklin Templeton Institute, wrote in a note. “The policy direction taken by Germany in the next four years will set parameters for the European Union and by extension, have a significant impact on the world economy.”
Assets have started to price the prospect of a result that supports further borrowing: German bonds have slipped versus key benchmarks, with longer-dated securities falling more than those with shorter maturities, pushing the yield curve to its steepest since 2022. That’s because additional borrowing tends to weigh more on longer tenors.
Meanwhile, the country’s benchmark DAX gauge of stock prices has climbed to a record high — driven in part by a 45% rally this year by Rheinmetall AG, the only pure-play defense stock in the index — and euro currency options are tilted in favor of more gains early this week.
Companies in the defense sector are poised to benefit from any fiscal reform that frees up capital for more investment in Europe’s military. These stocks have already been on a tear this year, with Citigroup Inc. analysts noting before a rally last week that boosting spending on defense to 2.5% of GDP, up from 2%, would increase equity valuations of these companies by 15-20%.
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The euro has benefited from the inflows into German stocks this year, and closed the week at $1.0458. The common currency is on track to gain almost 1% in February, its best monthly performance since August. And data from the Depository Trust & Clearing Corporation show that 60% of options placed this year to expire Monday are targeting a stronger euro. That’s despite broader concern that the currency could ultimately fall through parity with the dollar this year.
Much of the euro’s long-term trajectory hinges on whether investors believe the US dollar has peaked. Speculative traders, including hedge funds and asset managers, curbed their bets on further dollar gains for a fifth-straight week through Feb. 18, data from the Commodity Futures Trading Commission show.
Still, there are signs that German politicians, including Merz, recognize the need for greater borrowing — although in one of his final pitches to voters on Friday, Merz said loosening restrictions on government borrowing “isn’t a priority.” Germany has the capacity to borrow more, with some of the lowest costs and smallest debt piles in the euro area.
And the odds of a less market-friendly outcome — one in which smaller parties combine into a blocking minority that makes fiscal reform difficult — are at 55%, Goldman Sachs Group Inc. said in a note dated Feb. 18.
What Bloomberg economists say...
“The main danger is that the poll yields another fragmented parliament. This could leave a power vacuum at the heart of Europe during a particularly challenging time and, eventually, result in a government that is too weak to implement much-needed reform.”
— Tom Orlik, Bloomberg Economics, Chief Economist. Full note here.
The stakes domestically are also high. Germany’s economy shrank in 2024 for a second consecutive year, only the second time that’s happened since 1950. Years of underinvestment, the loss of cheap Russian gas and a long-running slump in China — a key trading partner — have weighed on output, prompting soul-searching about how Germany can reignite growth.
Inconclusive results risk prompting months of political wrangling to form a workable coalition and delaying economic policies. A surprisingly strong result for the far-right Alternative for Germany could also shake markets, a risk that FX strategists warn is being overlooked.
Expectations for post-election volatility in the euro are muted, with the cost to protect against swings in the election aftermath trading around 100 basis points below the average seen so far this year.
Markets pricing reflects “optimism that debt brake reform in Germany looks clearer on Monday,” said Jordan Rochester, head of FICC strategy at Mizuho International. “I think the risk-reward skews the other way.”
--With assistance from Isolde MacDonogh and Vassilis Karamanis.
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