European bond yields surged due to higher deficits, with German bonds performing poorly. The DAX rose, the euro strengthened, and oil prices dropped amid economic concerns.

European government bond yields surged over 40 basis points (bps) this week following deficit increases announced by several European countries. German 5-year and 10-year bund yields rose 40-50 bps, reflecting a projected deficit increase of 1.2-1.3%. The yield spread between 10-year U.S. Treasuries and German bunds narrowed to its lowest level since 2023. This sharp rise in yields has driven bond prices lower. German 10-year bunds saw their worst performance since 1997. As German bund yields serve as the benchmark for Eurozone debt, Spanish, French, and Italian bond yields have also climbed. Equity markets were mixed, with most indices declining. However, Germany’s DAX outperformed, rising over 1.4% for the week and nearly 17.5% year-to-date. The DAX is trading above its historical 12-month forward price-to-earnings (PE) multiple. Meanwhile, the euro strengthened by 4.49% against the U.S. dollar, rallying sharply following the European Central Bank (ECB) meeting. Brent crude oil prices fell 3.6%, pressured by OPEC+’s decision to increase production in April. The expanded supply weighed on prices. Additionally, uncertainty over potential U.S. tariffs on Canada, Mexico, and China has heightened fears of economic slowdowns. Concerns over weaker crude demand are rising.

The ECB cut rates to 2.50% to support growth amid weak Eurozone performance, with inflation easing but economic uncertainties limiting recovery.

The European Central Bank (ECB) has reduced interest rates to 2.50%, the sixth cut since mid-2024, to alleviate restrictive monetary conditions amid a stabilizing but weak Eurozone economy. While inflation is moderating, the ECB signals caution on further cuts, with fiscal stimulus and rising bond yields potentially influencing decisions. The ECB's growth projections are modest, with GDP expected to grow by 0.9% in 2025 and inflation at 2.3%. Eurozone inflation has eased, mainly due to weak demand and lower energy prices, but geopolitical risks remain. GDP growth for Q4 2024 was 0.2%, with Spain leading at 0.8% QoQ. Business activity showed marginal growth in February, with weak demand and rising inflation. Retail sales dropped 0.3% in January 2025, reflecting consumer concerns, despite wage growth. The outlook remains fragile, with ongoing economic uncertainties affecting business and consumer confidence, leading to modest growth expectations for 2025.

The ECB cut rates to 2.50% to ease restrictive policy but signalled uncertainty over further cuts. Fiscal stimulus and rising bond yields may influence future decisions.

The ECB is lowering key interest rates for the sixth time since summer 2024, reducing the deposit rate by 25bp to 2.50%, as it seeks to ease restrictive monetary conditions amid a Eurozone economy showing tentative signs of stabilization but no clear recovery. This rate, crucial for banks and savers, reflects the central bank’s efforts to support growth as inflation moderates—currently at 2.4%—and geopolitical uncertainty persists, including looming US tariffs on European goods. However, the outlook for further rate cuts is less clear. The ECB’s updated guidance—describing policy as "meaningfully less restrictive" instead of "restrictive"—signals that rates are approaching neutral territory, leaving the door open to further cuts but with greater caution. The latest ECB staff projections, which forecast GDP growth at 0.9% in 2025, 1.2% in 2026, and 1.3% in 2027 alongside inflation of 2.3%, 1.9%, and 2.0%, respectively, were based on data from two weeks ago and did not factor in recent fiscal developments. These include Germany’s proposed €500bn infrastructure fund, discussions on increased European defense spending, and potential changes to Germany’s debt brake. If fiscal stimulus materializes, it could significantly improve the Eurozone’s growth outlook, reducing the need for further monetary easing. However, rising bond yields, with German 10-year bunds surpassing 2.4%, could tighten financial conditions and increase borrowing costs, potentially prompting yield curve control discussions.

Given the increased uncertainty, we expect the ECB to cut rates only once more this year, bringing the deposit rate to 2.25%, assuming no political setbacks in Germany or abrupt macroeconomic shifts. The neutral rate could be between 2% and 2.25%.

Eurozone inflation has eased with declines in core and energy prices. Weak demand and geopolitical uncertainties influence the outlook while the ECB debates further rate cuts.

Eurozone inflation has moderated, with headline inflation declining from 2.5% to 2.4% and core inflation falling from 2.7% to 2.6%. Price growth in the services sector also eased slightly, from 3.9% to 3.7%, while energy prices experienced a notable reduction, dropping from 1.9% to 0.2%. This overall decline is primarily attributed to weak domestic demand, which is outweighing the reported rise in input costs, thus complicating efforts for businesses to pass these costs onto consumers. Despite higher input costs, consumers have regained some purchasing power, though concerns regarding the broader economic climate and elevated savings rates persist. Consequently, inflation in the Eurozone is anticipated to remain slightly above 2% in the coming year, supported by a gradual improvement in domestic demand driven by enhanced purchasing power and lower interest rates. However, geopolitical risks, such as trade uncertainties and energy price fluctuations, add an element of unpredictability to the inflation outlook. For the ECB, the critical issue remains how far to reduce rates, with some members of the governing council expressing concerns about excessively aggressive rate cuts.

We expect the ECB to continue lowering rates due to Europe's weak economy; however, we do not foresee a scenario where rates approach 0%.

Eurozone GDP grew 0.2% in Q4 2024. Consumer spending and investment increased, but exports declined, while inflationary pressures persist.

Eurozone's GDP for Q4 2024 grew by 0.2%, slightly surpassing previous forecasts, although this remains one of the region’s weaker performances of the year. The largest economies, Germany and France, contracted by 0.2% and 0.1%, respectively, while Italy saw a modest growth of 0.1%. Spain posted a strong 0.8% QoQ growth and a 3.5% YoY increase, outpacing other major economies in the region. Household final consumption expenditure increased by 0.4%, and government final consumption expenditure also rose by 0.4%, contributing to overall growth. Gross fixed capital formation increased by 0.6%, while exports and imports both decreased by 0.1%. Despite these positive revisions, the broader economic outlook remains cautious, with persistent productivity challenges hindering a full recovery. Consumer spending has been slow to gain momentum, with purchasing power not translating into substantial consumption growth. Investment continues to face constraints, and the export sector remains under pressure, reflecting weak external demand. Employment figures showed a modest increase of 0.1%, but declining productivity per worker contributed to higher unit labour costs, which rose by 1.5%, sustaining underlying inflationary pressures.

We anticipate subdued growth in the first half of the year, followed by a modest recovery in the second half.

The Eurozone economy shows marginal growth in February with weak demand, rising inflation, and workforce cuts. Spain leads in growth, while France struggles. The outlook remains fragile.

The Eurozone economy showed continued, albeit fragile, expansion in February, with the composite output PMI index holding steady at 50.2, just above the neutral 50.0 mark but still well below the long-term average of 52.4. Demand conditions remained weak as new business volumes shrank further, and workforce numbers declined for the seventh consecutive month. Inflationary pressures rose, with input costs increasing at the steepest pace in almost two years, prompting businesses to raise their charges by the sharpest amount since April 2024. Among the Eurozone nations, Spain recorded the strongest growth with a composite PMI of 55.1, followed by Ireland at 53.4 and Italy at 51.9. In contrast, Germany saw only modest expansion with a PMI of 50.4, while France was a significant drag with a PMI of 45.1, its lowest in 13 months. While services showed growth despite weakening new orders, manufacturing activity continued to contract, albeit at a slower pace. Input costs remained elevated, leading to a sharp rise in output prices, especially in the services sector. Business sentiment for the future weakened slightly from January, reflecting ongoing geopolitical uncertainties and concerns over the impact of international developments on consumer spending.

We expect business activity to remain weak and stagnant at current levels, at least in the first half of the year. Companies are concerned about the potential tariffs that could be imposed by Trump.

Eurozone retail sales declined 0.3% in January 2025, with stagnating volumes despite wage growth. Economic concerns, rising unemployment fears, and increased savings limit consumption recovery.

Eurozone retail sales declined by 0.3% in January 2025 compared to December 2024, continuing the downward trajectory observed since September 2024. Although sales rose by 1.5% YoY, this marks the fourth consecutive month of stagnation in sales volumes, with current levels 0.6% below the peak recorded in September. Food, drink, and tobacco sales increased by 0.6%, while non-food product sales (excluding automotive fuel) decreased by 0.7%, and automotive fuel sales in specialized stores fell by 0.3%. Despite a notable recovery in purchasing power, driven by wage growth outpacing inflation, consumption has yet to experience a robust rebound, as concerns about the economic outlook and rising unemployment fears have prompted a higher savings rate. However, the unemployment rate has reached a historic low of 6.2%, indicating a tight labour market. Looking ahead, while the improved purchasing power is expected to support consumption, the extent of any recovery will largely depend on consumer confidence and their propensity to spend.

We foresee that ongoing uncertainty will constrain consumer spending in the first half of the year, contributing to modest and sustained GDP growth.