Written by Samer Hasn, Senior Market Analyst at XS.com
The euro continues its gains for the fourth day against the US dollar, rising by 0.2% and reaching its highest level since November of last year, touching 1.08205.
The euro’s gains come supported by optimism about the future of the region’s economy, especially its largest economy, Germany, with plans for an unprecedented increase in defence and infrastructure spending. This increase will require reforming the debt rules to open the way for expanding bond issuance, which will push their yields up sharply, which will also enhance the euro’s gains.
The likely new German Chancellor Friedrich Merz said that the new government will establish a 500-billion-euro infrastructure investment fund.
This growing momentum around reforming public finances in Germany and accelerating the pace of spending contributes to restoring hope about the possibility of restoring absent economic growth in Germany and enhances confidence in it, which may justify the euro’s recovery. The deepening economic concerns flowing from negative data and surveys in Germany and the eurozone were among the most important factors keeping the single currency under continuous downward pressure.
With this news about spending, experts have begun to raise outlooks for economic growth in the recession-stricken country, according to the Wall Street Journal. Morgan Stanley said that the spending packages could reach more than a trillion euros. Bank of America said that German economic growth could increase by between 1.5% and 2% in 2027. The Kiel Institute for the World Economy said that a temporary increase in military spending of 1% of GDP could lead to a 0.25% increase in long-term productivity.
The Journal also reported that Merz’s plan could boost economic confidence at a time of increasing geopolitical uncertainty and encourage investment and consumption.
On the other hand, this significant rise in bond yields indicates that financing costs could rise. The yield on German 10-year bund has reached its highest level since October 2023, approaching 3%. This potential rise in borrowing costs could make the plan to increase spending more expensive and burden the economy.
The future of the plan to increase spending and reform debt legislation is still unclear. It requires a constitutional amendment that must be approved by the German parliament, which ends its term this month. The new parliament includes a blocking minority made up of far-left and far-right parties that do not support the approach pushed by Merz, according to Reuters. The shape of the coalitions in the next parliament is also unclear at this time.
While failure to pass these reforms in conjunction with a commitment to increase defence spending could increase the economic burden by raising taxes and reducing government support for other programs.
Aside from that, the euro’s gains are also due to the weakness of the dollar in light of the successive negative signals from the US economy, which is surrounded by uncertainty about the consequences of the escalation of the trade war mainly. This has led to a decline in consumer confidence and business sentiment according to recent surveys from both The Conference Board and S&P Global.
The very negative surprise in the change in non-farm employment from ADP has deepened economic concerns. While uncertainty over Donald Trump’s policies and the decline in consumer spending have led to layoffs and slower hiring, according to Nela Richardson, chief economist at ADP.
Today, the market is looking ahead to the European Central Bank’s interest rate decision, with expectations of a 25bp cut. The focus will be on the press release and speech that follows the announcement. A softer tone from the central bank on the outlook for monetary policy could wipe out some of the recent gains from the euro.
These mixed factors and the lack of complete certainty around them could leave the euro vulnerable to sharp volatility, especially after the unusual rises we have seen this week.