How long can fiscal policy stay accommodative amid higher yields?

Citi's research indicates that Europe's more supportive fiscal policy could encounter obstacles due to increasing government bond yields. Despite this, public spending is anticipated to continue fostering economic growth through 2027, according to the bank's analysis. The euro area is projected to generate a positive fiscal impact equivalent to around 0.4 percentage points of GDP in 2026, consistent with national draft budget plans.

However, Citi expects less fiscal expansion in Germany and a smaller contractionary effect in France than what is outlined in these plans. This surge in stimulus is particularly notable given that the euro area already operates with an underlying primary budget deficit. EU recovery funds from the NextGenerationEU program further bolster fiscal policy.

Citi anticipates fiscal policies to stay expansionary in 2027, though the effect should diminish and become more evenly distributed among European economies. The bank attributes this growth to domestic demand, which is set to play a more significant role due to geopolitical tensions, industrial competition, and recurring supply disruptions weakening the traditional export-led model.

To counteract these challenges, increased spending on defense and economic autonomy may be necessary. However, Citi has adjusted its predictions for policy rates and European government bond yields since April, raising concerns about debt-servicing costs as governments refinance existing obligations. Moreover, public finances face competing demands from an aging population, defense requirements, and taxpayers who are already experiencing relatively high tax burdens.

Political uncertainty also poses a hurdle, as strong Eurosceptic parties and unresolved national budget issues may limit agreement on shared European borrowing and fiscal risk-sharing arrangements. Investors may seek greater compensation for holding sovereign debt if governments find it challenging to balance these competing priorities.

Citi's outlook suggests fiscal stimulus can support near-term growth; however, higher borrowing costs and political divisions could increasingly hinder governments' spending flexibility in the future.