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

By Stefano Rebaudo, Yoruk Bahceli and Lucy Raitano

March 5 (Reuters) - German long-dated bonds saw their biggest sell-off in years, the euro jumped to its highest level in almost four months and stocks rebounded on Wednesday after the parties in talks to form Germany's new government agreed to try to loosen its 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 infrastructure.

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

Elsewhere, Germany's Greens will negotiate hard before potentially giving their much-needed backing to debt reforms proposed by the conservatives and Social Democrats, parliamentary co-leader Katharina Droege said on Wednesday.

"It’s clearly a big change. The market is pricing in fiscal risk. It’s part of the risk premium that before was more priced into the UK curve or the US curve and now clearly needs to emerge also in the European curves," said Annalissa Piazza, fixed income research analyst at MFS Investment Management.

Germany's 10-year yield, the euro zone's benchmark, climbed 30 basis points (bps) to 2.785%, in its biggest daily rise since mid-March 2020, at the height of the pandemic crisis.

"'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."

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 24 bps to 3.069% in its biggest daily jump since October 1998.

Germany was set to raise 5 billion euros from a new 30-year bond on Wednesday, according to LSEG's IFR.

"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 23 bps to 2.241%, its biggest daily jump since March 2023.

"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, saying 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 widened to 105.1 bps after dropping below 100 bps for the first time since 2021 early in the session.

"What’s changed is there is more convergence now because there’s less bearishness about Germany. Everyone was obsessed with German deindustrialization, and the German economy was fundamentally broken, there was no way back," said Dario Perkins, managing director, global macro at TS Lombard.

"That narrative is changing, and that's just changing the interest rate, growth differentials within the euro area."

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 1.4% at $1.0771 EUR= at its highest level since early November, having risen more than 3.7% since Monday. Its rise against the yen was more moderate, climbing 0.5% to 160.01 EURJPY=.