Financial markets seem to be betting big on an ideal outcome from Sunday’s German federal elections. Across multiple asset classes, investors are pricing in the expectation that a new government will push for additional fiscal spending—either by easing the debt brake or through alternative mechanisms. But with so much optimism already factored in, what happens if reality doesn’t match expectations?

Markets Are Expecting More Spending

The anticipation of increased government spending has already led to notable moves in financial markets:

• The euro has strengthened against the dollar.
• European equities have outperformed their global peers.
• European bond yields have risen, reflecting expectations of higher government spending.

This market positioning suggests that investors believe a new coalition will successfully implement policies that boost fiscal expansion. But what if those expectations aren’t met?

The Risks Are Skewed to the Downside

There’s a real possibility that parties opposing increased spending could secure enough seats (more than one-third in the Bundestag) to block any constitutional changes needed to loosen Germany’s strict fiscal rules. If that happens, we could see a sharp reversal in recent market trends:

• The euro could weaken as confidence in fiscal stimulus fades.
• European equities may slump as growth expectations are revised downward.
• European bond yields could fall, reflecting lower borrowing and spending prospects.

UBS’s FX strategy team has outlined these risks in their latest FX Compass, while European economist Felix Hüfner provides a detailed breakdown of possible election scenarios.

With markets already pricing in the best-case scenario, any deviation from that could trigger a sharp sell-off across multiple assets. As election results unfold, investors should brace for potential volatility—because when expectations are high, the downside risks are even higher.