By Dhara Ranasinghe and Alun John

LONDON (Reuters) -The euro and European stock futures rallied on Tuesday, while German Bund futures fell after the parties hoping to form Germany's next government agreed to create a 500 billion euro ($529.80 billion) infrastructure fund and overhaul borrowing rules.

The news, which came after the close of European markets, marks a tectonic spending shift to revamp the military and revive growth in Europe's largest economy.

The euro rallied and was last trading at $1.0608, more than 1% higher on the day and at its highest level in three months. Against Britain's pound, the euro traded 0.4% higher at 82.91 pence.

German and European shares are expected to open higher on Wednesday, as futures, which had fallen earlier in the day on U.S. tariff worries, rose.

German Dax futures were last down 1.5% on the day after the benchmark Dax index closed down 3.5%.

"It sends a clear signal that Germany is serious about its defence, it sends a clear signal to Ukraine and at home it sends a clear signal that Germany is serious about infrastructure spending," said Berenberg chief economist Holger Schmieding.

"This is an excellent start for the new German government. This strengthens Europe and should underpin euro gains although there are trade risks to consider."

Deutsche Bank said on Tuesday it had turned more positive on the euro's outlook following the headlines from Germany.

"The news flow is significant enough to now shift us into an outright EUR/USD bullish view," Deutsche analysts said, adding that the bank now targets euro/dollar at $1.10.

European defence company shares have soared in recent days as momentum to ramp up defence spending across the region gathers pace.

But for bond markets, signs that additional spending could create more government bond issuance were expected to add upward pressure on bond yields.

Germany's Bund futures turned sharply lower on the news. They were last down 1%.

"Details around the announcement will of course be key. But this is an important step to significantly ease German fiscal policy and to start reversing years of underinvestment into the domestic economy and on defence spending," said Marchel Alexandrovich, economist at consultancy Saltmarsh Economics.

In addition, markets were processing a Reuters report that U.S. President Donald Trump's administration and Ukraine plan to sign a much-debated minerals deal.

($1 = 0.9438 euros)

(Reporting by Alun John and Dhara Ranasinghe; Editing by Lisa Shumaker)