March 5 (Reuters) - German long-dated bonds saw their

worst selloff in years and the euro jumped to its highest level

in almost four months on Wednesday after the parties in talks to

form Germany's new government agreed to try to loosen the

country's fiscal rules.

European stock indexes recorded robust gains after sharp

declines in the previous session.

The German political parties concerned want to make higher

defence and federal state spending possible and to create a 500

billion euro ($535 billion) special fund to boost the country's

infrastructure.

Friedrich Merz's conservatives and the Social Democrats

(SPD) will put their proposals to parliament next week.

"'Don't underestimate Germany's capacity to change' was our

hypothesis into the year and just as most people gave up on

Europe," said Maximillian Uleer, strategist at Deutsche Bank.

"Today, Germany announced a 'Whatever it takes' plan."

Germany's 10-year yield, the euro area's benchmark, climbed

20 basis points (bps) to 2.69%, in its biggest daily rise since

mid-March 2020, at the height of the pandemic crisis.

However, most analysts question how quickly Germany could

deploy such a large amount of money.

"It's a significant move (in financial markets) but it has

to be a significant move given the size of these packages," said

Jens Peter Soerensen, chief analyst at Danske Bank.

"When people realise this is not coming tomorrow but it's

coming over 10 years, how big a reaction should we have?"

Germany's 30-year yield was up 18 bps after

rising almost 25 bps to 3.07% in its biggest daily jump since

October 1998.

"Higher spending is likely to weigh on the longer end of the

curve. We thus close our long duration call on Bunds," Deutsche

Bank's Uleer added.

Money markets reduced their bets on European Central Bank

rate cuts, pricing in a depo rate of 2.02% in December

from 1.92% late Tuesday.

Germany's 2-year yield, more sensitive to ECB

policy rates, rose 15 bps to 2.16%.

"This proposal (to loosen the debt brake) could ultimately

mean even more new debt than the earlier media reports about a

combined 900 billion euros package for defence and investment,"

said Christoph Rieger, rate strategist at Commerzbank, arguing

that "the military component is in principle unlimited."

The EU Commission President Ursula von der Leyen said on

Tuesday the EU will activate the escape clause of the stability

and growth pact, removing limits on defence spending.

"Moreover, the measures could also give the future

governments more fiscal space beyond military and investment in

the upcoming budgets," Commerzbank's Rieger added.

The spread between the risk-free 10-year overnight index

swap (OIS) and Bund yields dropped to -23 bps, its

lowest level since August 2010.

The yield gap between Italian and German debt

was roughly unchanged at 102 bps after dropping below 100 bps

for the first time since 2021 early in the session.

Joint European Union borrowing for new investments will be

crucial to support government bonds for highly indebted

countries, like Italy and France.

The single currency jumped as investors eyed the

prospective increases in fiscal spending, which could boost the

economy.

The euro was up 0.6% at $1.0687, after hitting

$1.0722, its highest since November 11, and jumping by almost 3%

since Monday. Its rise against the yen was more moderate,

climbing 0.13% at 159.40.

"The euro/dollar broke decisively higher on prospects of a

fiscal bazooka out of Europe. The speed with which the Europeans

are moving is impressive, especially in Germany," said Chris

Turner, forex strategist at ING.

"Expect much focus now on whether the agreed fiscal changes

in Germany move swiftly and easily through parliament over

coming weeks," he added.