Germany’s Game-Changing Election

The country’s politics are getting a boost of uncharacteristic urgency from coming Chancellor Friedrich Merz, with even the constitutional “debt brake” up for grabs.

This week’s CIO Weekly Perspectives comes from guest contributors Patrick Barbe and Maximilian Korell.

Turnout for Germany’s election a week ago was 82.5%, the highest since reunification. Faced with economic stagnation, the rise of the far right, the potential for an end to the war in Ukraine, and possibly the end of 80 years of U.S. security commitments, the voters clearly saw it as a high-stakes poll.

Opening statements on coalition negotiations and fiscal spending from Germany’s coming Chancellor, Friedrich Merz, suggest that he recognizes the high stakes, too.

The market has responded: The euro is up, European stocks and especially German defense names are up, and the recent rally in 10-year U.S. Treasuries has not been followed by German Bunds. But the response is perhaps not as strong as the headlines might have suggested.

Are there doubts about how impactful this election will turn out to be, or are investors simply waiting to confirm the direction of travel?

Grand Coalition

The market was arguably wrongfooted by the election result. The far-right Alternative für Deutschland (AfD) doubled its vote share, but investors seem to have been priced for a bigger rightward shift. Markets also appear to have expected at least two or three of Germany’s minor parties to cross the 5% vote threshold that confers Bundestag seats, but in the end only the far-left Die Linke party managed it.

That is significant, as it makes it possible for Merz’s Christian Democrat Union/Christian Social Union (CDU/CSU) to command a majority in a “Grand Coalition” with the Social Democratic party (SPD) alone. There is an ideological gap between the two parties on tax-and-spend issues, but a Grand Coalition of the two centrist parties is still the easiest to negotiate and the most likely to enact quick and substantial policy changes.

Merz has promised “constructive, good, swift talks” with the SPD. On the table, reports suggest, is a quick approval of an extra €200 billion ($210 billion) of special defense spending even before coalition details are agreed on. That would represent a big jump relative to the €100 billion fund initiated by Chancellor Olaf Scholz back in 2022. Should that fail to materialize, we think the new government, once formed, will be prepared to invoke the “escape clause” in the European Union fiscal rules, citing the country’s economic stagnation, to loosen the purse strings.

That helps explain the outperformance of German defense stocks and the underperformance of long-dated German government bonds. So, what is holding investors back from a more thorough repricing?

Debt Brake

The big prize for European investors would be an end to the “debt brake,” the 2009 balanced budget amendment to Germany’s constitution that restricts its annual structural deficit to just 0.35% of GDP.

On the face of it, that would require a two-thirds majority in the Bundestag, which means carrying all the votes from the CDU/CSU, SPD, the Green party and Die Linke. But Merz caused a stir the day after the election by noting that the Bundestag “can make decisions at any time,” suggesting that Germany’s centrist parties could change the debt brake using their outgoing two-thirds majority, which technically remains valid until March 24.

That would be highly unorthodox and we think it unlikely—but the mere mention of it signals the strength of Merz’s commitment to fiscal loosening. All four parties agree on the need for flexibility to tackle Germany’s investment backlog, but Die Linke appears averse to raising spending purely for defense. Allocating something to domestic social and infrastructure expenditure could be enough to secure its support.

Movement on the debt brake is therefore closer than it has ever been. Even so, it is not a done deal.

Pro-Growth Partnership

As a result, the bond market still primarily trades on its policy expectations from the European Central Bank (ECB) rather than its policy expectations from Germany. The German yield curve’s recent steepening has been driven by the short end falling rather than the long end rising, as much of Europe’s economy, and especially the French services sector, struggles to escape stagnation.

In early February, ECB staff released their latest estimate of the neutral nominal policy rate, which suggested there is still room for between 50 and 100 basis points of further cuts. The market already anticipates the first 25 to come when the ECB meets this week. We think the real market movers are more likely to be the central bank’s new economic forecasts (which will incorporate December and January’s important wage data), and the tone of ECB President Christine Lagarde’s commentary (in the light of the German election result).

A German Grand Coalition, led by a notably Europhile Chancellor Merz, has the potential to lay the foundations for a pro-Ukraine, pro-growth partnership encompassing Emmanuel Macron in France, Giorgia Meloni in Italy and Ursula von der Leyen at the European Commission. It could release much-needed fiscal impetus at a time when both France and Italy face budget constraints.

If that prospect triggers a turn from dovish to neutral commentary from the ECB, we may see a more decisive bid for the euro and a more marked rise in rates across the German yield curve.