Eurozone in Flux: A Macro Assessment

It has been a tumultuous start to 2025 for the Eurozone – Trump tariffs, struggling economies, and an impending election in the largest economy have left risk managers scratching their heads. With the German election just days away, this is an opportune time to assess the current state of macro Europe, and what to watch out for in the months ahead.

ECB: Further Cuts on the Horizon

At its first meeting of the year, the ECB committee delivered on market expectations and cut rates 25bps, bringing the depo rate down to 2.75%. Markets anticipate a further 50bps of cuts in the next two meetings, and a total of 75bps for the remainder of the year. The debate surrounding the Eurozone’s “neutral” rate – a rate which is neither materially restrictive nor accommodative – continues, and although exact numbers (and even practicality) are disputed, the general consensus range lies between 2.5% and 1.8%. The next anticipated cut will bring rates into this range, potentially reaching the lower end by December.

Risks to this pricing are most readily found in President Lagarde’s comments on inflation – whilst headline inflation is expected to return to 2% by year-end, upside risks persist, driven by energy concerns and the impact of tariffs. Core inflation presents an even greater concern. Despite some progress, wage growth and certain services inflation remains too high, and ECB members are eager to avoid a second wave of inflation.

Trump Tariffs: Renewed Trade Tensions

In early February, President Trump reimposed tariffs on steel and aluminium imports from the EU, effectively dismantling previous trade agreements. The move has reignited trade tensions, with estimates suggesting a potential 0.1% hit to EU GDP, particularly impacting Germany, France, and Italy.

Economists warn that these measures could drive inflation higher and increase stagflation risks on both sides of the Atlantic. Markets are closely monitoring the EU’s response, with European Commission President von der Leyen promising a “firm and proportionate” reaction. In a move reminiscent of the 2018 trade dispute, the EU has threatened reciprocal tariffs on U.S. exports, including key industries such as agriculture, whiskey, and motorcycles.

Whilst discussions with U.S. officials have focused on addressing global overcapacity—particularly from China— retaliatory measures remain on the table. However, EU trade responses require unanimity, meaning internal divisions could delay action.

The stakes are high: further escalation could weigh on growth, whilst failure to act decisively may leave European industries exposed to further competitive pressure.

Germany’s Economic Woes and Political Strife

Germany's economy is currently facing significant challenges, with recent data indicating a GDP contraction over the past two years. High energy costs, partly due to geopolitical tensions and the political decision to turn off nuclear, have eroded industrial competitiveness, leading to increased unemployment rates. The upcoming federal election on Sunday is pivotal, as citizens demand substantial economic reforms. Leading candidates, such as Friedrich Merz of the CDU, are under pressure to address issues like excessive bureaucracy, labour shortages, and the need for technological advancement. Proposed solutions include revising fiscal policies, investing in infrastructure, and fostering innovation to revitalize Europe's largest economy.

A key sticking point in Germany is the restrictive debt brake – this policy limits the amount of net borrowing the country can make to 0.35% of GDP annually, a level of fiscal conservatism not matched in the EU’s other major economies. Repealing or circumventing the brake could unleash a wave of issuance from the state. Whilst the impact of subsequent investment will take time to materialise, the initial increase in borrowing will keep upward pressure on rates across the European curve. If this investment reignites German growth, no one will look back with regret. However, if lacklustre growth continues and the rate environment crept higher in the longer end of the curve because of the efforts, the ECB could face the challenge of navigating stagflation.

Whilst inaction seems to be the greater evil, no route is without significant risk – following Sunday’s election, we will quickly begin to see which path the new, likely coalition, government takes.

Risks Lie Ahead

Given the number and magnitude of the issues facing Europe, whether the outcome is positive or negative, one can be certain of volatility in the coming months. The Euro rates curve is currently flat, from 1y out to 10y the swap curve is hovering between 2.30% and 2.40%, when adjusting for credit this implies an ECB rate within their neutral range described earlier. A naïvely optimistic interpretation might suggest that the market believes the ECB has played its hand perfectly and won’t need to enact serious rates moves in the coming years. A more realistic assessment points to uncertainty.

With significant pressures keeping rates elevated – lingering inflation, additional borrowing, tariff threats – and similarly significant risks to rates lower – lacklustre growth, rising unemployment – risk managers need to keep on top of moves whilst having the framework in place to act quickly.

From a volatility standpoint, the currency situation is no different, although recent market moves have perhaps tilted the balance of risk in one direction. After a terrible end to 2024 for EURUSD, the recent Trump threats and weak economic data had many market participants once again looking toward parity, but it didn’t materialise. Recent Euro negative news has been met with muted reaction in FX, and we actually sit some 2.2% off the year-to-date lows.  With speculative positioning still very short EUR (close to 2020 levels on some measures), marginal sellers may be hard to come by. Typically, this is a perfect environment for a jump higher in an asset – time will tell if we get the news required to topple the first domino.