German bazooka will lift growth but tariff threats loom large

In this note we give our initial take on the macro, rates and FX implications of Germany's debt brake announcement. This note also replaces the FX Weekly for this week.

Germany’s ‘whatever it takes’ moment to shake economy out of its rut

While much will depend on the timing and composition of new spending, we judge a reasonable base case that growth will be boosted by 0.1pp in 2025, with a much bigger boost of 0.7pp expected for 2026, and likely a further positive impulse in 2027. All else equal, and given our baseline of weak growth on the back of US tariffs, this would raise our growth forecast for Germany to 0.5% in 2025 and to 1.4% in 2026. With Germany making up around 1/3 of the eurozone economy, this would also mechanically lift our eurozone growth forecast by 0.1pp to 1.2% in 2025, and 0.3pp to 1% in 2026 (with potential for spillovers). Due to the significant near-term uncertainty around new US trade tariffs, we refrain from raising our growth forecasts at this point (see below). As such, these estimates should be taken as indicative of the impact new spending would have by itself.

With that said, we do not wish to downplay the significance of this announcement: aside from the clear geopolitical necessity, it is a massive step-change and one that the German economy desperately needs, with the potential to lift German industry out of the structural malaise it has fallen into. Indeed, one aspect we do not take into explicit account (as it is inherently unpredictable), is the potential for positive confidence effects on growth, which could come ahead of actual spending.

Growth boost likely to be a 2026 (and beyond) story

The most consequential for the near-term growth outlook is the €500bn infrastructure fund, to be disbursed over 10 years. Were it to be spent evenly over that ten years, this would be equivalent to a c1.1% direct boost to GDP. Compared to other forms of fiscal easing, infrastructure spending typically has a relatively high multiplier: most of the money is spent in the domestic economy rather than stimulating higher imports, and unlike tax cuts, the money has to be spent and cannot be saved. In the longer run, the benefits to the economy extend beyond the direct impact, as improved infrastructure tends to also raise productivity growth. On the other hand, infrastructure spending depends on projects being ready and approved, and although supply-side constraints are much less than in the post-pandemic period, it may take time for the relevant industries to respond to the higher spending. As a result, while likely to be a major boost for the 2026 outlook, the impact in 2025 is probably limited.

We also expect the growth impact of higher defence spending to be back-loaded, but for different reasons to infrastructure spending. Germany currently spends 2.1% of GDP on defence; we assume this will be gradually raised to c3.5% of GDP by the end of 2026. This would fit with the broader call by the EU to raise spending by 1.5% of GDP, and Germany would still be well within the new EU fiscal rules (which theoretically allows a deficit of 4.5% of GDP including the new escape clause for defence). This sounds like a massive increase, and it is. However, its impact on GDP growth will be significantly blunted in the near-term by Europe’s reliance on imports for defence equipment. EU estimates suggest that some 80% of military procurement is currently done outside the EU. Meanwhile, the recent experience of Poland – which saw a similarly sharp jump in its defence spending between 2022-24 (from 2.2% to 4.1%) – showed that such a sharp increase in so short a time period typically goes largely to higher equipment procurement than other kinds of spending. Although Poland also significantly increased its military personel numbers, some 65% of the increase in its spending went to military equipment, most of it imported. As such, we assume that around half of the increase in Germany’s defence spending will at first go to higher imports. For the remainder of spending, research suggests the fiscal multiplier of defence spending is relatively low initially (perhaps as low as 0.5). Over time, this may increase substantially, via boosts to productivity from R&D and greater economies of scale, but this will probably not materialise until later in our forecast horizon or beyond.

Could defence spending be the saviour of the German car industry?

Likewise for imports, European countries – Germany included – will surely seek to procure more domestically over time, but this will not happen overnight. Some German car part makers have hinted at a re-orientation to defence, and for good reason: much of the car industry suffers from significant overcapacity, with clearly much more hidden slack in the labour market than is suggested by the unemployment rate alone. But it is unclear how quickly industry can retool and workers re-skill to produce weaponry and military vehicles.

We will have much more to say more broadly on the implications of higher defence spending for the eurozone economy over the coming weeks and months, but our initial take is that the growth impact will take time to materialise – this will be more of a 2026 story.

Fiscal boost not the only driver in town: Tariffs are a massive near-term risk

While the fiscal bazooka is rightly dominating headlines right now, Germany (and the eurozone) also is on the brink of a potentially massive rise in tariffs on its exports to the US. On 2 April the administration is expected to come with new tariffs on the car sector and pharma (among others), as well as so-called ‘reciprocal tariffs’ which seek to correct for something that is not actually a trade barrier – VAT. If the administration were to go ahead with all of its threats, this would represent a much bigger growth shock than we currently have in our base case (see here). The proximity of this announcement is the main reason that we refrain from making formal changes to our forecasts at this point.

What does this mean for the ECB?

All else equal, the fiscal boost from both Germany and defence more generally in the eurozone raises the risk of both a higher terminal rate and perhaps more near-term caution than our current base case, which sees rates falling to 1% by early 2026. Even before the recent news, we had already penciled in a pause in rate cuts at the April meeting, with low conviction over this timing due to the high degree of uncertainty over tariffs. The ECB continues to indicate ambiguity over how it views the impact of tariffs on inflation, and this – alongside the fiscal boost – could stay the Governing Council’s hand for longer. Our view is that a trade war with the US will ultimately be disinflationary for the eurozone. But, as described above, the ECB's resumption of rate cuts rests on the ultimate size and timing of US tariffs.

And is the bazooka really a done deal?

In order for the changes to the debt brake to pass, a 2/3 majority of the existing Bundestag is necessary, and will need to be done before 25 March. This requires the Greens to join the SPD and Union in voting for the changes. There has been some indication of opposition to the form of infrastructure spending (the Greens leader said ‘special funds are not the honest way, debt brake reforms are the cleaner solution’). And Linke has suggested it may legally challenge some of the changes it opposes (on defence spending), although it is in favour of infrastructure spending, and any legal challenge would take time to materialise. Overall, we judge the risk that politics or legal challenges will derail the plans are small.

What does it mean for Bund yields?

Following the introduction of the investment plan, we judge that most of the related news has now been digested by the market. The expectation of increased government spending and future bond issuance is clearly exerting upward pressure on bund yields, a trend likely to persist in the near term. However, based on preliminary calculations, the most significant impact on the German deficit and the rise in bond issuance is anticipated to occur next year. We forecast the German deficit to widen, reaching between 3% and 3.5% in 2026, and to remain within this range in the following year. Consequently, this would result in an additional funding requirement of between EUR 50 billion and EUR 70 billion for 2026. We think that while the market can absorb this issuance, it might require an additional premium to do so. However, in the event of a flight-to-quality, demand could potentially increase, helping to rebalance any supply and demand imbalances.

In the medium to long term, we expect the deficit to stabilize, followed by a decline due to higher economic growth, which we assume will more than compensate for structurally higher spending. Consequently, we view this investment plan as credit-positive for Germany, as it was essential to revitalize its economic model. Additionally, this will likely generate positive economic spillovers across the rest of Europe.

We will soon publish an update to our interest rates forecast in light of the recent developments. Overall, European government bond yields will be revised higher than our current base case for 2025. However, based on our macroeconomic outlook and ECB view, we still anticipate yields to decline from the second half of the year onwards.

And what about the euro?

EUR/USD has recovered since 13 January which is one week before the inauguration of Donald Trump. Since then the EUR/USD has risen by more than 5%. The EUR/USD is close to the level of after the US elections outcome. On 6 November EUR/USD stood at 1.0930. EUR/USD now stands at 1.0795. EUR/USD cleared the 200 day moving average level. This is a sign of a change in trend. Why has EUR/USD rallied considerably?

First, 10-year rate spreads (nominal and real) between the US and Germany and the US and Japan have moved in favour of the yen and the euro. Until recently this was mainly because of lower US yields. But since the start of March the 10y German government bond yield has risen sharply because of large defence spending in Germany and other European countries. Second, policies and announcements by the Trump Administration have made investors concerned about the outlook for the US economy. As a result, financial markets are now pricing in a total of rate cuts of 74bp this year compared to 57bp last week. Meanwhile financial markets now price in a total 68bp of rate cuts by the ECB this year compared to 82bp last week. So expectations about monetary policy have also weighed on the dollar versus the euro. Third, uncertainty about future policy of the policy of the Trump Administration is also a negative for the dollar. More and more the market is shying away from the dollar as the US is at the centre of creating uncertainty about the economy and the geopolitical situation. Currently speculators are possibly neutral to slightly net long euro and neutral US dollar. So positions are in no way extreme to dampen the move.

As mentioned above currently the dynamics are positive for the euro versus the dollar but based on our views on the Fed, ECB and bond yields we expect weakness in EUR/USD again. The risks have increased that we may not reach parity because the US policy uncertainty is also weighing on the dollar and technical dynamics could result in buying on dip behaviour of investors. If financial markets were to turn very risk averse we expect only the US dollar and the Japanese yen to rise.