The euro has been on the rise for the second consecutive trading day, hitting a multi-month high. But what is driving this sudden strength in the currency? The key reason lies in the European Union’s (EU) plan to increase defence spending by hundreds of billions of euros.
With global geopolitical tensions rising and the United States halting military aid to Ukraine, the EU is now preparing to take control of its own defence strategy. But how will this impact Europe’s economy, its financial markets, and investors?
More importantly, what does it reveal about understanding currency markets and how global events shape exchange rates?
What Is Driving the EU’s Defence Spending Plans?
This week, European Commission President Ursula von der Leyen made a major announcement: the EU is set to mobilize €800 billion to boost its defence capabilities. This comes after the U.S. administration suspended all military aid to Ukraine, raising concerns about European security.
Von der Leyen stated that Europe is entering "an era of rearmament" and must prepare for the challenges ahead. To achieve this, the EU plans to increase defence spending without violating budget deficit rules.
But how exactly will this be done? The proposal includes:
● Encouraging EU member states to raise their defence spending by 1.5% of GDP, unlocking €650 billion over the next four years.
● Extending €150 billion in loans to further finance military development.
● Allowing nations to increase military expenditure without triggering the 3% GDP deficit limit, an EU rule designed to maintain financial stability.
How Is Germany Leading the Push for Higher Military Budgets?
One of the biggest supporters of this plan is Germany’s Chancellor-in-waiting, Friedrich Merz. He announced that Germany will increase defence spending beyond 1% of GDP, signaling a major shift in the country’s fiscal policies.
However, Germany faces a challenge—its “debt brake” law, enacted in 2009, limits the government’s budget deficit to 0.35% of GDP. This means the country has strict controls on how much it can borrow.
How Is the European Investment Bank Getting Involved?
Another major development is the European Investment Bank’s (EIB) potential role in defence financing. According to reports, the bank is considering expanding its mandate to fund military-related projects.
Currently, the EIB—with a balance sheet of €600 billion—can only finance projects that have both civilian and military applications. If its rules are changed, it could help direct more funds into Europe’s defence sector.
How Is the Euro Reacting to These Developments?
The financial markets have responded positively to the EU’s defence spending plans. The euro climbed above 1.06 against the U.S. dollar, marking its highest level since November 12, 2024.
But why is the euro strengthening?
● Investors view higher government spending as a stimulus for economic growth.
● Germany’s potential fiscal policy shift has raised optimism about a stronger economic recovery.
● Stock markets across Europe have reached record highs, further boosting confidence in the euro.
The European bond market has also reacted strongly.
● Germany’s 10-year bond yield settled at 2.48%, following a 9-basis point increase.
● France’s 10-year government bond yield climbed to 3.23%, hitting a one-week high.
How Does This Affect the British Pound?
The impact is not limited to the euro alone. The British pound has also strengthened against the U.S. dollar over the past two trading days.
Similar to the EU, the UK is witnessing political and economic shifts that are driving market optimism. As a result, UK government bond yields are rising, reflecting investor expectations of higher public spending in response to global security concerns.
Final Thoughts
The euro’s rally is a direct result of the EU’s plans to massively increase defence spending. With Germany leading the charge and the European Investment Bank considering new financing options, Europe is preparing for a major shift in its military and economic policies.
For investors, traders, and policymakers, the next few days will be crucial. Will Europe follow through with its ambitious spending plans, or will internal challenges slow progress?