European bond yields rose on ECB rate cut expectations, equities gained, the euro weakened, and Brent crude prices fell.

European long-term bond yields increased over the week, driven by recent economic data that strengthened expectations of a potential ECB rate cut in September. The yield spread between French and German benchmark bonds widened by 1.9 basis points. Equities had a strong performance, with all major indices closing in positive territory. The euro depreciated against the dollar, reaching an exchange rate of 1.1087. Meanwhile, Brent crude oil prices declined by nearly 2.50%, influenced by concerns over rising supply and the possibility of less aggressive rate cuts than previously anticipated.

Eurozone inflation fell to 2.2%, while core inflation remains high. Germany's economy contracted; a September ECB rate cut is likely.

Eurozone inflation decreased to 2.2%, mainly due to a 3% drop in energy costs, signalling gradual inflation improvement. Core inflation, however, remains elevated at 2.8%, influenced by rising services costs. This suggests that the European Central Bank (ECB) may cut rates by 25 basis points in September. In Germany, inflation fell to 1.9%, the lowest since March 2021, driven by lower energy prices, though services inflation persists. Germany’s economy contracted by 0.1% in Q2, facing weak consumption and construction. The August Ifo index also declined, reflecting persistent stagnation and uncertainty. Another rate cut and increasing wages could aid recovery by year-end.

Eurozone inflation dropped to 2.2% in August due to lower energy costs. Core inflation remains high, with Germany seeing a decline below 2%, suggesting an ECB rate cut.

Eurozone inflation decreased from 2.6% to 2.2%, primarily due to a 3% reduction in energy costs, reflecting a gradual improvement in the inflationary landscape. This decline suggests that the ECB is nearing its target of stabilizing inflation. However, core inflation remains elevated, with a slight reduction from 2.9% to 2.8%, influenced by lower goods inflation and a rise in services inflation to 4.2%, partly due to the impact of the Olympic Games in France - services inflation in France accelerated to 3.1% from 2.6%. While headline inflation is significantly affected by energy price fluctuations, core inflation—less susceptible to these variations—plays a crucial role in the ECB’s policy decisions. Despite expectations for a continued slowdown in inflation, core inflation is not anticipated to drop below 2.5% for the remainder of the year. For next year, weaker domestic demand and anticipated declines in wage growth should further ease inflation, though uncertainties regarding wage dynamics and energy costs, driven by geopolitical factors, persist. Given these trends and future expectations, the ECB is expected to implement a 25 bp rate cut in September.

In Germany, the inflation rate has fallen below 2% for the first time since March 2021, signalling an increasing likelihood of a rate cut at the ECB’s September meeting. The August flash estimate shows German inflation at 1.9% YoY, down from 2.3% in July, marking the lowest rate since March 2021. This disinflationary trend, driven by lower energy prices and favourable base effects, is observed across various sectors, including food, beverages, household goods, and transport. Nonetheless, services inflation remains high at approximately 4% YoY, and rising wages could present future inflationary risks.

Consistent with market expectations, we anticipate that the ECB will implement a rate cut in September, reflecting the prevailing economic weakness and declining inflation.

The German economy contracted in Q2 due to weak consumption and construction, facing ongoing stagnation and uncertainty.

The main European economy experienced a contraction in Q2, shrinking by 0.1% QoQ, following a 0.2% growth in Q1. This downturn was largely driven by weak private consumption, which fell by 0.2%, and a significant decline in the construction sector, with investments dropping more than 2%. Although government consumption increased by 1% and net exports underperformed, the overall economic outlook remains dim. Despite these challenges, there are still reasons for cautious optimism. A significant increase in real wages could boost consumer spending, and even a modest improvement in industrial orders might help reverse the inventory cycle. However, with consumer confidence declining, the path to recovery remains uncertain. The German economy continues to face a combination of cyclical headwinds and structural challenges, leading to stagnation as it struggles to regain its footing.

We anticipate that a rate cut in September, combined with rising wages, could initiate economic improvement in Germany by year-end, with continued recovery during 2025.

Germany's August Ifo index dropped for the fourth consecutive month, highlighting persistent economic stagnation amid weak global conditions, geopolitical tensions, and domestic uncertainties, with limited signs of recovery.

Germany’s August Ifo index underscores fear of prolonged stagnation, marking its fourth consecutive monthly decline to 86.6, down from 87.0 in July, as Germany’s economy shows no signs of recovery. Following last week’s disappointing PMI figures, the drop in the Ifo index—Germany’s leading economic indicator—reflects a weaker current assessment and declining expectations, dispelling the optimism seen earlier this year. The German economy remains the eurozone’s growth laggard, affected by a weaker global economy, concerns over a slowing U.S. economy, geopolitical tensions, and domestic policy uncertainty. Additionally, increasing insolvencies and job restructuring announcements threaten the labour market, a key pillar of economic strength. While there are few reasons for optimism, a rise in real wages could boost consumer spending, and even a slight improvement in industrial orders might spur production. This current phase of economic stagnation is marked by a mix of cyclical headwinds and structural changes, making it a complex scenario rather than a typical economic downturn.

We expect Germany to be the primary drag on Eurozone economic growth in the upcoming two quarters and the whole of 2024.