Europe's backing for Ukraine 'turbocharges' arms shares

By Amanda Cooper, Dhara Ranasinghe and Paolo Laudani

LONDON/GDANSK (Reuters) -Investors piled into European arms manufacturer shares and punished long-dated government bonds on Monday, following the clearest sign yet the region's leaders were racing to increase defence spending and help to secure peace in Ukraine.

A flurry of European diplomacy, including an agreement to spend more on defence, followed an acrimonious meeting between President Volodymyr Zelenskiy and U.S. President Donald Trump on Friday.

The euro rose by as much as 0.7% to $1.045, as investors flocked to the European equity market, where an index of aerospace and defence companies hit record highs.

Europe has faced pressure to spend more on its security following Russia's invasion of Ukraine three years ago, and the need to act has become urgent, as the Europeans, including Ukraine, have been sidelined in talks between Washington and Moscow.

Reuters reported on Monday that parties in talks to form Germany's new government are considering setting up a defence fund. Investors sold off 30-year German debt, which pushed yields up by more than 10 basis points.

"It is an inflection point and Europe realises it needs to do the heavy lifting (on defence and security)," RBC Capital Markets Global Macro Strategist Peter Schaffrik said.

"The German elections have opened the door for more spending. The whole Zelenskiy-Trump meltdown has fast forwarded everything."

Francois Savary, chief investment officer at Genvil Wealth Management, agreed.

"We are nearing a tipping point if they (European leaders) get their act together," he said. "My bet is something is going to come, as the pressure is building."

By mid-morning in Europe, shares in the region's biggest defence company BAE Systems had risen around 15%, while those in Germany's Hensoldt, which provides sensor systems for the Eurofighter, jumped 22% to a record high.

Leopard 2 tank maker Rheinmetall rose 12%, while Italy's state-controlled defence group Leonardo jumped 11% and Europe's largest defence technology company Thales was up around 13%.

JPMorgan analysts said the events of the last two weeks have "turbocharged" their thesis of a European rearmament cycle.

"There are 30 European countries in NATO and we expect many of them will soon commit to much higher defence spending," they said in a note.

The EU believes 500 billion euros ($523 billion) in investments are needed over the next decade. But raising defence spending to 3% of output would require nearly 200 billion euros per year more.

BONDS SELLOFF

Long-dated government borrowing costs soared in France, Italy and Britain too, as investors sold bonds on Monday.

Italian 30-year yields were up 7.4 bps at 4.28%, while French 30-year yields rose nearly 9 bps to 3.81% and 30-year gilts rose 5 bps to 5.14%.

Germany's 30-year bond yields, up over 10 bps, were set for their biggest one-day jump since April.

Britain on Sunday announced an order for 5,000 lightweight multirole missiles (LMM) for Ukraine, trebling production of the air defence missiles at the Belfast factory of Thales.

And in Germany, two special funds potentially worth hundreds of billions of euros, one for defence and a second for infrastructure, are being mulled, Reuters reported.

Deutsche Bank Chief Economist Robin Winkler said a "paradigm shift" appeared to be taking place.

"Even if spent over 10 years, this would be about as much money as the country has invested in East Germany since reunification," Winkler said in a note.

"In other words, it would be a fiscal regime shift of historic proportions."

($1 = 0.9553 euros)

(Reporting by Paolo Laudani, Anna Pruchnicka in Gdansk and Amanda Cooper and Dhara Ranasinghe in London, additional reporting by Tim Hepher, editing by Alun John, Kirsten Donovan and Barbara Lewis)