Euro area yields, stocks, euro jump as German parties agree on fiscal loosening

March 5 (Reuters) - German long-dated bonds saw their worst selloff in years and the euro jumped to its highest level in almost four months on Wednesday after the parties in talks to form Germany's new government agreed to try to loosen the country's fiscal rules.

European stock indexes recorded robust gains after sharp declines in the previous session.

The German political parties concerned want to make higher defence and federal state spending possible and to create a 500 billion euro ($535 billion) special fund to boost the country's infrastructure.

Friedrich Merz's conservatives and the Social Democrats (SPD) will put their proposals to parliament next week.

"'Don't underestimate Germany's capacity to change' was our hypothesis into the year and just as most people gave up on Europe," said Maximillian Uleer, strategist at Deutsche Bank.

"Today, Germany announced a 'Whatever it takes' plan."

Germany's 10-year yield, the euro area's benchmark, climbed 20 basis points (bps) to 2.69%, in its biggest daily rise since mid-March 2020, at the height of the pandemic crisis.

However, most analysts question how quickly Germany could deploy such a large amount of money.

"It's a significant move (in financial markets) but it has to be a significant move given the size of these packages," said Jens Peter Soerensen, chief analyst at Danske Bank.

"When people realise this is not coming tomorrow but it's coming over 10 years, how big a reaction should we have?"

Germany's 30-year yield DE30YT=RR was up 18 bps after rising almost 25 bps to 3.07% in its biggest daily jump since October 1998.

"Higher spending is likely to weigh on the longer end of the curve. We thus close our long duration call on Bunds," Deutsche Bank's Uleer added.

Money markets reduced their bets on European Central Bank rate cuts, pricing in a depo rate of 2.02% in December EURESTECBM7X8=ICAP from 1.92% late Tuesday.

Germany's 2-year yield DE2YT=RR, more sensitive to ECB policy rates, rose 15 bps to 2.16%.

"This proposal (to loosen the debt brake) could ultimately mean even more new debt than the earlier media reports about a combined 900 billion euros package for defence and investment," said Christoph Rieger, rate strategist at Commerzbank, arguing that "the military component is in principle unlimited."

The EU Commission President Ursula von der Leyen said on Tuesday the EU will activate the escape clause of the stability and growth pact, removing limits on defence spending.

"Moreover, the measures could also give the future governments more fiscal space beyond military and investment in the upcoming budgets," Commerzbank's Rieger added.

The spread between the risk-free 10-year overnight index swap (OIS) EUREON10Y= and Bund yields dropped to -23 bps, its lowest level since August 2010.

The yield gap between Italian and German debt DE10IT10=RR was roughly unchanged at 102 bps after dropping below 100 bps for the first time since 2021 early in the session.

Joint European Union borrowing for new investments will be crucial to support government bonds for highly indebted countries, like Italy and France.

The single currency jumped as investors eyed the prospective increases in fiscal spending, which could boost the economy.

The euro was up 0.6% at $1.0687 EUR=, after hitting $1.0722, its highest since November 11, and jumping by almost 3% since Monday. Its rise against the yen was more moderate, climbing 0.13% at 159.40. EURJPY=

"The euro/dollar broke decisively higher on prospects of a fiscal bazooka out of Europe. The speed with which the Europeans are moving is impressive, especially in Germany," said Chris Turner, forex strategist at ING.

"Expect much focus now on whether the agreed fiscal changes in Germany move swiftly and easily through parliament over coming weeks," he added.