[Reuters Analysis] For markets, German fiscal splurge blurs ECB outlook

• Traders curb ECB rate cut bets after German fiscal proposal, ECB
• ECB cuts rates but statement seen as mildly hawkish
• Bond yields post historical surge, euro at four-month high

LONDON, March 7 (Reuters) - A tectonic shift in German fiscal policy has compounded uncertainty for traders trying to bet on how fast the European Central Bank will cut rates for the rest of the year, with a change to the bank's guidance on Thursday reinforcing that.

The ECB cut rates by 25 basis points to 2.50% in its sixth move since last June. But it said that monetary policy was becoming "meaningfully less restrictive," rather than the "restrictive" used before.

That supported traders, who had already reduced bets on ECB rate cuts after a deal from Germany's next coalition partners on Tuesday to create a 500 billion euro ($541.40 billion) infrastructure fund and overhaul borrowing restrictions, partly to boost defence spending.

"We could have potentially one more cut, a maximum of two," said Aviva Investors senior economist Vasileios Gkionakis, noting the ECB's change in language was a win for the policy hawks and meant to signal that an end to rate cuts is coming.

Following the ECB's meeting, traders further curbed their bets on an April rate cut, now seeing less than a 50% chance of a quarter point move, down from over 60% last week.

Indeed, policymakers also see a growing chance of an April pause before they lower rates again, once there is greater clarity about trade and fiscal policy, sources told Reuters.

By year-end, traders price in around a 60% chance of two rate cuts to follow Thursday's, having priced in a chance of a third move last week.

FISCAL VS MONETARY BOOST

Markets are hoping Germany's bold move to rip up its fiscal playbook may be a game-changer for Europe's economy.

The euro EUR=EBS surged to $1.0854 on Thursday, the highest since November 6, the day after U.S. President Donald Trump's election, and well above the near $1.01 levels seen in February, as tariff worries weighed.

Germany's bond yields, the benchmark for the euro zone, were set for their biggest weekly jump since the early 1990s as markets braced for a surge in borrowing DE10YT=RR.

Remarkably, traders have even moved to price in the chance that the ECB will start to raise rates again next year, given that the fiscal boost could lift inflation, seeing a roughly 40% chance of a hike by September 2026.

With little detail available and the German proposal yet to be approved, it wasn't a factor for the ECB's decision on Thursday, but it further blurs the monetary policy outlook, which analysts had already seen as less certain.

"If you throw that much money into an economy, you are going to get quite a difference. It also means inflation will be higher," said RBC BlueBay Asset Management chief investment officer Mark Dowding.

A key market gauge of inflation expectations EUIL5YF5Y=R surged following Germany's announcement. It is trading at around 2.22%, only slightly above the ECB's 2% target, and posted its biggest daily jump on record on Wednesday, according to LSEG data going back to 2013.

Dowding reckoned the ECB's next rate cut could be its last.

"We've been selling short-dated German bonds, thinking the rates market has been pricing in too many rate cuts," he said ahead of the ECB decision.

Banks, including Goldman Sachs and Nomura, have also reduced their rate cut forecasts.

For markets, uncertainty around the ECB's next moves is a marked departure from the near-certain expectation of a rate cut at every ECB meeting since October.

ELEPHANT IN THE ROOM

For all the market optimism around a sea change to the bloc's growth outlook, the big question mark is still U.S. tariffs.

It remains unclear if such measures will be implemented against Europe. The ECB mentioned trade uncertainty as a factor for ongoing weakness in investment as it revised down its growth forecasts.

Aluminium and steel tariffs goes into effect on March 12, but Europe could get hit by substantial reciprocal tariffs as well as separate measures against its automotive sector and other industries.

"Markets are underestimating tariffs," said Fidelity International's global head of macro and strategic asset allocation Salman Ahmed.

He expects the ECB to reduce rates to 1.75% rather than the 1.5% anticipated earlier, but added that the central bank would likely respond to tariffs by further cutting rates.

Danske Bank chief analyst Piet Christiansen said he had not yet revised his call for the ECB to cut rates to 1.50% this year, citing the scale of uncertainty around Germany's fiscal proposals.

"You have the number, but that's all you have. You don't have when it's going to be deployed, at what scale."

($1 = 0.9235 euros)

G10 rates G10 rates on March 6, 2025

Euro zone inflation and ECB interest rates