Recent developments in the financial landscape have echoed the words of former European Central Bank president Mario Draghi: “In a dark room, you move with tiny steps. You don’t run, but you do move.”
The ongoing negotiations over tariffs, heightened geopolitical tensions, shifts in Europe’s defense spending strategies, and Germany’s fiscal changes have instigated notable fluctuations in the markets. However, a challenge arises with such announced policy shifts as their actual implementation remains uncertain, complicating the effects on the real economy and central banks.
In Europe, for instance, the German parliament recently approved changes to the fiscal debt brake alongside a significant fiscal package targeting infrastructure and defense expenditure. While this is a positive move, the specifics of these changes are still ambiguous.
Although we know that infrastructure spending can have a one-to-one multiplier effect, defense spending is likely to be a gradual contributor to growth, necessitating time to bolster production capacities for meaningful economic impact. Consequently, it raises the question of how the European Central Bank (ECB) will respond—will it react to the inflationary pressures from increased spending or focus on the immediate threat posed by US tariffs?
Given the evolving policy landscape, we have revised our macro and market forecasts, presenting a more optimistic growth outlook for the eurozone, alongside potentially rising inflation rates. We anticipate the ECB to halt rate cuts, stabilizing at a deposit rate of 2.25% by this summer.
Additionally, significant fiscal shifts, particularly from Germany, will likely drive government bond yields higher in the coming quarters, with 10-year German bond yields potentially surpassing 3%. We are navigating through a period of unprecedented uncertainty with a spectrum of macroeconomic outcomes.
While it may be tempting to remain passive, the approach should be cautious and deliberate—moving step by step while acknowledging that further revisions to our forecasts may be necessary in the future.