(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.
The euro rose as much as 0.7% in Asian trading after Germany’s conservative opposition leader Friedrich Merz comfortably won Sunday’s federal election, in line with expectations. Contracts on the benchmark DAX stock index climbed 1%, while bond futures edged lower.
“For the markets, the outcome is favorable because Germany will still have a centrist government but it will pivot to a more pro-business, pro-investment orientation,” said Matt Gertken, chief geopolitical strategist at BCA Research. The nation will also “have somewhat better odds of avoiding a massive split with the Trump administration over trade, Russia, or China,” he said.
Merz’s CDU/CSU bloc won 28.8% of the votes, followed by 20.2% for the Alternative for Germany, according to estimates from public broadcaster ARD. The Social Democrats finished third with 16.2%, the party’s worst result since World War II. Speaking Sunday evening, Merz said he wants to form a new government as soon as possible, noting the world “won’t wait for us” to have lengthy coalition talks.
In a best-case scenario for markets, Merz would 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.
For Krishna Guha, vice chairman of Evercore ISI, a two-party coalition with the CDU/CSU and SPD and enough potential support from other parties to reform the brake would be “the best available outcome for Europe, Ukraine and financial markets.”
That would mark a sea-change 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.
Ahead of the election, assets had already started to price in the prospect of a result that supports further borrowing: German bonds have slipped versus key benchmarks, with longer-maturity securities falling more than shorter-dated ones, 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 — driven in part by a 45% rally this year by Rheinmetall AG, the only pure-play defense stock in the index.
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% to 20%.
The euro has also benefited from the inflows into German stocks this year, and has now gained about 1.5% in February. About 60% of options placed this year to expire Monday are targeting a stronger euro, according to data from the Depository Trust & Clearing Corporation. That’s despite concern the currency may ultimately weaken through parity with the dollar this year.
“The euro has been bogged down by the structural weakness in Germany, which should take a turn to the better if the new government follows through with reforms and takes a more active role on infrastructure and defense,” said Dane Cekov, a senior macro and FX strategist at Sparebank 1 Markets AS. “However, this election result will not be a game changer for the euro, as Trump’s incoming tariffs will hurt the euro ahead.”
Much of the common currency’s long-term trajectory also 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 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, he 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.
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.
“There’s not a lot of room for disappointment in equity markets at the moment, and in the very short term, this could be a positive,” said Neil Birrell, chief investment officer at Premier Miton Investors.
--With assistance from Isolde MacDonogh, Vassilis Karamanis, Ira Iosebashvili, Allegra Catelli, Sagarika Jaisinghani and Matthew Burgess.