European stock markets rallied on Friday as news of an agreement between German political parties on a historic debt deal added to optimism that has swept across the region, but analysts warned of the challenges ahead.

German government bond yields, equities and the euro all rose on Friday on reports Germany's Chancellor-in-waiting Friedrich Merz had reached an agreement with the Greens to reform debt rules and massively increase state borrowing.

The euro and European stock futures rallied, 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.

Germany's likely next chancellor Friedrich Merz said Friday his conservatives had struck a deal with the Greens on massively boosting defence and infrastructure spending, paving the way for the plan's approval in parliament.