Germany's fiscal stimulus redraws eurozone economic map

Donald Trump’s tariff threats materialised against multiple trading partners, including the EU, with a 25% tariff imposed on aluminium, steel and related products. The EU’s countermeasures are set to impact over €25 billion of US imports, although this only affects 1% of US goods entering the EU.

While forecasts for weighted US tariffs remain subject to the US Trade Department’s review of unfair foreign trade practices, a baseline prediction of 10% helps paint the picture of potential GDP downturns resulting from ongoing trade hostilities.

Economic repercussions of export tariffs vary across EU member states, with Spain appearing most resilient while Germany and Italy remain more exposed. However, the direct inflationary impact of these tariffs is expected to be limited due to factors such as exchange rate effects, a potential reorientation of Chinese goods towards the EU market, and the likelihood that European consumers will bear a significant portion of the tariff costs. Moreover, a potential slowdown in overall economic activity within the EU could further dampen any inflationary pressures arising from the trade dispute.

Against this backdrop, the EU is seeking greater autonomy to shield itself from macroeconomic instability, with Germany announcing a bold fiscal package that has caused reverberations through the bond markets and recalibrated monetary policy expectations. This fiscal expansion, combined with the risk of a US trade war and the volatile dynamics of global energy markets, sets the scene for a pivotal moment in Europe’s economic trajectory.

The German government’s recent historic amendment to its Basic Law represents a significant departure from its traditionally conservative fiscal stance.

The amendment paves the way for a fiscal package that includes a €500 billion infrastructure investment fund, €100 billion of which will be allocated to a climate change fund. Most notably, the country’s debt brake has been adjusted to allow for greater military and civil defence manufacturing, cybersecurity investment, and support for Ukraine.

The package incorporates the principle of additionality, requiring Germany's federal government to allocate at least 10% of its budget to investment before accessing the fund for new projects.

Despite uncertainties about the specifics of Germany's spending plans, taking into account the military spending target of 3% of GDP and the likely front-loading of infrastructure investment has raised GDP growth forecasts by up to 0.8% in 2025 and 1.5% by 2026.

The success of the fiscal policy hinges on Germany's ability to maintain a stable deficit, which remains likely as GDP growth is sustained while inflationary pressure is expected to remain marginal or zero.

This fiscal impetus arrives at a crucial juncture for the European Central Bank (ECB), with headline inflation expected to fall to 2.1% by April and core inflation to 2.3%. This easing of inflationary pressure is driven by continued low energy prices and a slowdown in notoriously sticky services inflation, which dropped by 0.2% in February.

Anticipating this, the ECB is widely expected to cut rates by 23 basis points in both April and June, reaching a 2% deposit rate. However, market scepticism remains, with only a 50% chance of the April cut currently priced in.

Bond markets reacted strongly to Germany's announcement, with the 10-year Bund yield rising, driven by increased term premiums reflecting higher growth expectations and potentially less accommodative monetary policy.

Upward revisions to Eurozone growth are driving these higher rates, with the 10-year Bund yield forecast to remain between 2.7% and 2.9% until Germany's fiscal plan is implemented, potentially reaching 3% depending on new economic data and the plan's execution.

Term premiums are expected to increase further, driven by a steeper EUR curve, with 10-year premiums already up by 40 basis points since February. This trend is likely to continue as bond issuance increases from €265 billion in 2025 to a forecast high of €350 billion in 2026. Germany, poised to become the largest gross supplier of bonds in the Eurozone, is expected to further support this trend, potentially pushing the 10-year Bund yield to 3% by the final quarter of this year.

Germany's fiscal plan is also having a positive impact on sovereign spreads, potentially boosting growth across the Eurozone and providing a tailwind for credit and equity markets. While fiscal efforts in other Eurozone states could theoretically increase public debt, this is not currently anticipated.

In the US, the Federal Reserve has kept rates unchanged, signalling economic uncertainty partly due to tariff concerns. The Fed projects two rate cuts this year, but markets anticipate more.

The energy sector remains crucial for Europe's economic outlook. The Russia-Ukraine war significantly influences energy price formation for 2025, impacting inflation. While the US seeks a resolution, its approach – potentially involving unacceptable concessions for Ukraine, such as banning Nato membership and land concessions – differs from Europe's commitment to Ukrainian sovereignty and existing sanctions against Russia. This divergence suggests a limited impact on Russian energy flows to Europe, which has largely diversified its sources.

In the oil market, despite potential shifts in US policy, the fundamental outlook for the second half of 2025 appears bearish, with expectations of strong supply from OPEC (1.3 million barrels a day) and relatively weak demand (1 million barrels a day). While OPEC agreed to unwind some of its current production cuts, there are doubts about the market's capacity to absorb this additional supply. Increased Iranian oil exports, even with US sanctions, also contribute to this view, with Brent crude expected to trade around $70 per barrel in the latter half of the year.

The natural gas market in Europe presents a different picture. With Russian pipeline gas unlikely to return in 2025, Europe will continue to rely heavily on liquefied natural gas (LNG) imports. To secure sufficient supply, European gas prices will need to compete with Asian demand, suggesting a price level of around €45 per megawatt-hour for 2025. The absence of Russian pipeline gas means that European gas storage will need to be replenished throughout the summer, further supporting this price outlook.

The Eurozone stands at a pivotal moment. Germany’s bold fiscal policy will inject much-needed stimulus into the economy and reshape expectations for growth and interest rates. While the path ahead is not without its challenges, including the looming US trade war and the complexities of the global energy market, the current trajectory suggests a potentially more robust economic outlook for the Eurozone. The interplay between proactive fiscal policy, a responsive ECB, and the evolving global landscape will be crucial in determining the success of this newfound momentum.