Euro zone stocks rally as German parties agree historic fiscal deal

• German parties agree deal to massively boost spending
• European stocks rally, euro gains
• German 10-year Bund yields eye 3%

LONDON, March 14 (Reuters) - European stock markets rallied on Friday as news of an agreement between German political parties on a historic debt deal added to optimism that has swept across the region, but analysts warned of the challenges ahead.

Germany's benchmark DAX .GDAXI index was up almost 2%, while mid- .MDAXI and small-caps .SDAXI rose over 3% each, The euro gained 0.5% to $1.0907 - taking its gains so far this month to 5%.

The trigger for the latest euphoria was a source-based report that German chancellor-in-waiting Friedrich Merz had reached an agreement with the Greens on a massive increase in state borrowing in Europe's largest economy.

It is the latest sign of fast-moving developments to ramp up defence and infrastructure spending that economists expect will boost Germany's long-term growth profile and in turn that of the broader euro bloc.

"They’ve managed to get over the first hurdle. There are a lot of challenges still to come," said Nicholas Rees, head of macro research at Monex Europe in London.

"In Germany it takes a long time to spend money. So, despite the fact markets are very optimistic right now, we think they’re going to be disappointed."

Others analysts too noted that the speed of the rally across European markets as well as the selloff in the German bonds -- as investors anticipate increased bond supply to fund spending -- was likely to be tempered as caution sets in.

Germany's benchmark stock index is set for its best quarter since 2020, with gains of over 15%, while benchmark 10-year Bund yields are set for the biggest quarterly jump since 2022.

The 10-year Bund yield was last trading at 2.9%, up 8 basis points on the day DE10YT=RR.

"This is positive for Germany but there are questions marks on how quickly the plans can be delivered," said Rabobank head of rates strategy Richard McGuire. "The speed at which the funds can be deployed is questionable."

Merz wants the outgoing German parliament to approve a 500 billion euro fund for infrastructure and sweeping changes to borrowing rules to revive growth and ramp up military spending in the continent's largest economy.

Analysts said Bund yields would likely struggle to push significantly above the 3% mark for now.

The euro EUR=EBS meanwhile rallied 0.5% to $1.0903, and was up 1.3% against the yen EURJPY=EBS and 0.5% against the pound EURGBP=D3.

Further euro gains were also likely to be limited, analysts said, with worries about U.S. tariffs likely to temper sentiment.

U.S. President Donald Trump on Thursday threatened to slap a 200% tariff on wine, cognac and other alcohol imports from Europe, opening a new front in a global trade war that has roiled financial markets and raised recession fears.

"We certainly expect euro-dollar to retrace lows, we’re looking for euro-dollar to hit $1.03, as the market starts to price out some of these easing expectations in the U.S., as it becomes apparent these recession fears are overblown… and we’ve still got tariffs coming (on Europe)," said Rees at Monex Europe