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Markets last week
Summary
Projected incoming German Chancellor, Friedrich Merz announced a nearly €1trn fiscal package for defence and infrastructure, marking a historic shift from Germany’s fiscal conservatism in response to US policy changes on Ukraine
Markets reacted sharply, with German bund yields seeing their biggest one-day rise since 1990; bond yields across Europe also climbed as investors priced in broader fiscal expansion
The euro strengthened 4.4% against the US Dollar and European equities outperformed, led by aerospace, defence, industrials, and materials stocks benefiting from the spending surge
The European Central Bank (ECB) cut rates by 0.25% to 2.5%, but fiscal developments overshadowed monetary policy, raising uncertainty about future inflation and the pace of further cuts
US markets faced heightened volatility, with the volatility index (VIX) spiking above 26 and equities falling 3.1% amid policy uncertainty from the White House and shifting trade policy
Credit spreads widened, with US high-yield spreads reaching parity with European high yield for the first time since March 2023, reflecting broader risk aversion.
Market Review
Merz’s “whatever it takes” moment
German Chancellor-in-waiting Friedrich Merz grabbed headlines by announcing a massive fiscal package of nearly one trillion euros for defence and infrastructure. This marks a significant departure from Germany’s traditional fiscal prudence and is a direct response to the tectonic shift in global alliances as the US pauses support for Ukraine. Merz described the move as a “whatever it takes” moment to protect Europe, a phrase famously used by Mario Draghi in 2012 when, as President of the ECB, he pledged to do whatever was necessary to preserve the euro during the eurozone debt crisis.
The market reaction was swift and pronounced, with German bund yields rising the most in any single day since reunification in 1990. Over the full week the 10-year bund yield rose 43 basis points (bps) to close at 2.84%. Yields across Europe followed suit; many expect similar commitments from other European nations. The 10-year Obligations Assimilables du Trésor (OAT) – French government bonds to finance public spending - yield (France) rose 41bps to close at 3.55%, the 10-year BTP yield (Italy) rose 41bps to close at 3.96%, while the 10-year Gilt yield (UK) rose 16bps to close at 4.64%.
The increase in spending is expected to drive European growth creating a more supportive environment for the single currency and European risk assets. The euro strengthened 4.4% against the US Dollar and 1.6% against the pound. European equities continued their strong out-performance seen so far this year. Industries expected to benefit from the fiscal package led the rally, with aerospace and defence stocks rising 5.8%. Industrials and materials were the best-performing sectors.
Monetary policy announcements were overshadowed by fiscal events but the ECB cut rates by 0.25%, taking their deposit facility rate to 2.5%, a stone’s throw away from the long-run equilibrium – the neutral rate that is neither accommodative nor stimulative. The market expects two further cuts from the ECB this year to a neutral stance. The surge in government spending across the eurozone adds further uncertainty to the inflation backdrop and the potential for additional rate cuts from the ECB.
US turbulence continues
I have written before that a Trump presidency might be “high implied volatility, but low realised” – so far it is just high volatility. The VIX index, a measure of implied volatility (fear) in US equities has risen sharply since mid-Feb, from 15 to above 26 during the week, the highest for the year so far. US equities fell 3.1% and are now down for the year-to-date. The level of policy uncertainty coming from the White House is creating turbulence for risk assets. The tariff deadline on Tuesday was followed by a confused set of exemptions and delays which fed through into investor sentiment.
The decline was broad-based, with ten of eleven sectors posting losses. Financials and consumer discretionary were the worst performing falling 6% and 5.5% respectively, while health care was the outlier rising 0.15%.
Credit spreads have widened in the US in recent weeks with high yield spreads expanding from 2.56% in mid-February to 2.94% mid-week, trading on a par with European high yield for the first time since the regional banking crisis in March 2023.
The week ahead
Wednesday: US inflation
Our thoughts: Consumer prices are anticipated to have risen 2.9% for the year to the end of February, moderating slightly from 3% in January.
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