German election brings some relief to European markets, debt brake in focus

Updates prices following the European stock market close

By Yoruk Bahceli and Samuel Indyk

LONDON, Feb 24 (Reuters) - An election win for Germany's conservatives has eased concerns of political gridlock in Europe's biggest economy, though it failed to lift uncertainty around whether a new government can deliver fiscal reforms that would boost sluggish growth.

Germany's domestically-focused mid-cap stock index rose 1.4% on Monday, one of it biggest daily jumps this year, and the euro briefly touched a one-month high, as the conservatives looked most likely to form a two-party coalition with the Social Democrats.

"There is an immediate relief that there were no big nasty surprises in the election outcome, and a centrist-leaning government will persist and could even pivot more towards business and investment friendly policies," said Charu Chanana, Saxo's chief investment strategist.

Small-cap stocks .SDAXI rose 0.8%, while the blue-chip DAX index .GDAXI, driven by international revenues, rose a more modest 0.4% to just shy of last week's record high, outperforming Europe's broad STOXX 600 .STOXX index.

Yields on safe-haven German bonds, which move inversely to prices, were little changed. DE10YT=RR

ALL ABOUT THE DEBT BRAKE

Reflecting lingering investor caution, the euro - which briefly touched one-month highs above $1.05 - was just a touch higher on the day at around $1.0472 EUR=EBS.

The conservative Christian Democrats (CDU) under likely next chancellor Friedrich Merz now face tricky coalition talks and the prospect of an obstructive parliament after a surge in support for far-right and far-left parties.

The big question for markets is whether Germany can reform the "debt brake" that limits its structural budget deficit to just 0.35% of output.

Europe's largest economy contracted for a second straight year in 2024, with critics blaming the debt brake for years of underinvestment.

The CDU, Social Democrats and Greens failed to gain the two-thirds parliamentary majority needed to change the rule or to launch special funds to raise spending outside of it. While including the Left Party would make up the numbers, it opposes raising defence spending, expected to be a major part of any fiscal boost.

Still, the AfD, which opposes debt brake reform, did not do better than expected, while the liberal Free Democrats, which also oppose it, failed to enter parliament.

Analysts say debt brake reform would support euro area stocks, which trade at sharp discounts to U.S. peers, and the euro, which dropped to around $1.01 earlier in February on U.S. tariff risks.

Pepperstone strategist Michael Brown said Monday's euro pullback showed the market was realising policymaking and debt brake reform could remain complicated.

"Participants are hence paring back their expectations of significant fiscal stimulus being delivered in short order," he said.

Others saw a greater likelihood of change.

"The Left is in favour of reforming the debt brake so there's still a case for fiscal reform or fiscal easing. That's my reading," said Barclays' head of European equity strategy Emmanuel Cau, adding the election result was good news for stocks.

Investors expect only moderate reform to the debt brake, as Merz has shown openness to only limited change.

Spending expectations have nonetheless grown in recent days as markets assess Europe's capacity to find potentially hundreds of billions of euros to ramp up defence spending.

Shares of German defence stocks rose sharply on Monday with bellwether Rheinmetall RHMG.DE up nearly 5% to near a record high touched last week on hopes for a Ukraine ceasefire.

The additional yield Germany pays for longer-term borrowing over shorter-term debt remained near its highest since 2022 on Monday. DE2DE10=RR