Euro hits 3-month high as EU prepares to increase defense spending
The euro rose for a second straight day of trading after Germany's incoming Chancellor Friedrich Merz said the government would unlock billions of euros for defense and infrastructure spending. The announcement matched European Commission President Ursula von der Leyen's proposal to activate 800 billion euros in defense funding following U.S. President Donald Trump's decision to cut aid to Ukraine.
Europe in discussions on mobilizing defense funds
On Tuesday, von der Leyen said the EU plans to boost Europe's defense and military spending by activating a mechanism to mobilize 800 billion euros in special funds, declaring that Europe is "in an era of rearmament" and is "ready to massively increase its defense spending." The announcement came after Washington suspended all military aid to Ukraine on Monday.
The proposal would allow member states to increase their defense spending "without triggering the excessive deficit procedure," she said, referring to the 3% deficit threshold of gross domestic product (GDP). The commission is calling on member states to increase their defense spending by 1.5% of GDP on average, unlocking 650 billion euros over the next four years. It has also proposed extending 150 billion euros in loans, bringing the package to 800 billion euros to boost the bloc's spending. The proposal has yet to be discussed at a summit attended by the 27 national leaders in Brussels on Thursday.
Among EU member states, Germany faces fiscal spending constraints due to a "debt-break" law passed in 2009, which caps the government's budget deficit at 0.35% of GDP. Merz announced a plan to increase defense spending beyond 1% of GDP and could be exempt from debt-sharing. He said Germany must do "whatever it takes" to defend the country. His conservative party and the SPD, currently in coalition talks, have also proposed a special fund of 500 billion euros for infrastructure investment.
Germany's announcement to increase defense spending is seen as a major boost for the continent to urgently increase military budgets ahead of Thursday's summit. However, France and Italy may struggle to increase their spending due to limited fiscal capacity.
In addition, the European Investment Bank will propose expanding its mandate to finance projects dedicated to military use, according to a Bloomberg report. The bank has a balance sheet of 600 billion euros, but is currently only allowed to finance projects with civilian and military applications.
Euro hits three-month high
The euro rose above 1.06 against the US dollar on Tuesday, hitting its highest level since Nov. 12, 2024. The pair rose by more than 2 US cents in the past two trading days, alongside all-time highs in European stock markets, suggesting investors are growing confidence in the bloc's economic outlook amid plans to boost defense spending. A possible change in Germany's fiscal policy has further bolstered optimism about its economic recovery.
European government bond yields have also risen. Germany’s 10-year bond yield stabilized at 2.48% after a 9-point rise the day before, while the French 10-year government bond yield rose to 3.23%, hitting a one-week high on Tuesday. “This comes as the market braces for a significant increase in defense spending and the issuance to finance it,” Michael Brown, a senior research strategist at Pepperstone, wrote in a note.
The British pound also rose over the past two trading days against the dollar, reflecting similar political and economic dynamics, while UK shale yields rose.
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