With markets forecasting the end of an era of restrained fiscal policy, Germany’s most consequential election in years sets the stage for a shift toward more expenditure.
Following Germany’s conservative opposition leader Friedrich Merz’s resounding victory in Sunday’s federal election, the euro increased by 0.7% in Asian trade, as anticipated. Bond futures declined slightly, while contracts on the benchmark DAX stock index increased by 1%.
According to Matt Gertken, chief geopolitical strategist at BCA Research, “the outcome is favorable for the markets because Germany will still have a centrist government but will pivot to a more pro-business, pro-investment orientation.” Additionally, he stated that the country will “have somewhat better odds of avoiding a massive split with the Trump administration over trade, Russia, or China.”
Public broadcaster ARD reports that Merz’s CDU/CSU alliance received 28.8% of the vote, while the Alternative for Germany received 20.2%. With 16.2%, the Social Democrats had their lowest showing since World War II and came in third. Merz stated Sunday night that he wants to establish a new government as quickly as possible and that the world “won’t wait for us” to engage in protracted coalition negotiations.
Merz would build a solid alliance with one or two other mainstream parties in the best-case scenario for markets. Such a result would make it easier to implement measures that may revive Germany’s flagging economy and allow for adjustments to the debt brake, a 2009 constitutional borrowing cap.
According to Krishna Guha, vice chairman of Evercore ISI, a two-party coalition with the CDU/CSU and SPD, with sufficient potential backing from other parties, would be “the best available outcome for Europe, Ukraine, and financial markets,” according to Krishna Guha, vice chairman of Evercore ISI.
That would be a radical shift for Germany, which has always advocated budgetary discipline. However, such a change is now possible due to the US pressuring Europe to increase its defense budget.
Assets have already begun pricing in the possibility of an outcome that would encourage additional borrowing before the election: German bonds have declined compared to essential benchmarks, with longer-dated securities declining more than shorter-dated ones, causing the yield curve to reach its sharpest level since 2022. This is because longer tenors often bear the burden of greater borrowing.
Rheinmetall AG, the index’s sole pure-play defense company, has surged 45% this year, contributing to the nation’s benchmark DAX indicator of stock prices reaching a new high.
Businesses in the defense industry stand to gain from any budgetary change that increases funding for Europe’s armed forces. Before a rally this week, analysts at Citigroup Inc. noted that increasing defense spending to 2.5% of GDP from 2% would raise the share prices of these businesses by 15% to 20%. These stocks have already been on a rampage this year.
The inflows into German stocks this year have also helped the euro, which has risen almost 1.5% in February. A higher euro is the aim of around 60% of options put this year that expire on Monday, according to statistics from the Depository Trust & Clearing Corporation. This is despite worries that the currency would eventually depreciate this year due to parity with the dollar.
Dane Cekov, a senior macro and FX analyst at Sparebank 1 Markets AS, stated that if the new administration implements reforms and takes a more active role in infrastructure and defense, the euro’s fundamental weakness, which has been holding it back, should improve. “However, Trump’s impending tariffs will harm the euro going forward, so this election outcome won’t change anything.”
Whether or not investors think the US dollar has peaked will also significantly impact the common currency’s long-term direction. For a sixth week through February 18, speculative traders, including asset managers and hedge funds, reduced their wagers on more dollar gains, according to Commodity Futures Trading Commission data.
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 borrows more, with some of the euro area’s lowest costs and minor debt piles.
The stakes domestically are also high. Germany’s economy shrank in 2024 for a second consecutive year, only the second time 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, Vasilis Karamanis, Ira Iosebashvili, Allegra Catelli, Sagarika Jaisinghani, and Matthew Burgess.
