(Updates prices)

By Stefano Rebaudo, Yoruk Bahceli and Lucy Raitano

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

biggest sell-off in years, the euro jumped to its highest level

in almost four months and stocks rebounded on Wednesday after

the parties in talks to form Germany's new government agreed to

try to loosen its 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

infrastructure.

Friedrich Merz's conservatives and the Social Democrats

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

Elsewhere, Germany's Greens will negotiate hard before

potentially giving their much-needed backing to debt reforms

proposed by the conservatives and Social Democrats,

parliamentary co-leader Katharina Droege said on Wednesday.

"It's clearly a big change. The market is pricing in fiscal

risk. It's part of the risk premium that before was more priced

into the UK curve or the US curve and now clearly needs to

emerge also in the European curves," said Annalissa Piazza,

fixed income research analyst at MFS Investment Management.

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

30 basis points (bps) to 2.785%, in its biggest daily rise since

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

"'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."

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 24 bps to 3.069%

in its biggest daily jump since October 1998.

Germany was set to raise 5 billion euros from a new 30-year

bond on Wednesday, according to LSEG's IFR.

"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 23 bps to 2.241%, its biggest daily jump

since March 2023.

"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, saying

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

widened to 105.1 bps after dropping below 100 bps for the first

time since 2021 early in the session.

"What's changed is there is more convergence now because

there's less bearishness about Germany. Everyone was obsessed

with German deindustrialization, and the German economy was

fundamentally broken, there was no way back," said Dario

Perkins, managing director, global macro at TS Lombard.

"That narrative is changing, and that's just changing the

interest rate, growth differentials within the euro area."

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 1.4% at $1.0771 at its highest level

since early November, having risen more than 3.7% since Monday.

Its rise against the yen was more moderate, climbing 0.5% to

160.01.