Morning from Copenhagen.

Large sell-off in German bonds this morning after Merz now considers amending the constitution to lift Europe’s defense spending, which is a BIG deal as it might be the first step toward a more benign fiscal policy outlook in Europe overall, as the debt brake has been one of the main headwinds for the German economy.

The narrative that Germany could potentially remove the debt brake has existed for quite a while now, starting when the news about the election broke out, and the move seen today in European assets and bond yields is likely a result of that narrative “finally” materializing.

We have previously tapped into that narrative, speculating whether Germany would deliver a “fiscal bazooka” after the election, and Trump’s actions toward Ukraine have more or less secured that bazooka now. Despite the move in bond yields, this will bode very well for European risk assets, further reinforcing an already bullish European outlook in our models.

We continue to favor exposure to European risk assets, while we are more cautious on European duration—especially now that German issuance is on the table and inflation expectations are also starting to rise in Europe. The risk/reward of pursuing more ECB rate cuts is diminishing, and we prefer to play it in a spread to long SOFR at the moment. Long December SOFR vs. short December EURIBOR looks compelling here.

Chart 1: The European Outlook Continues to Improve