A series of data releases in December showed growth slowing more aggressively in the early fourth quarter as activity in the manufacturing and services sectors weakened. The decline in year-over-year data appears consistent with a recessionary downturn. 

Citi Economic Data Change Indices

To some degree, the economy is suffering from lagging effects associated with last year’s energy shock, exposure to a softening global industrial cycle, and the early stages of fiscal consolidation. But to a significant extent, the euro area’s slowdown looks policy induced. 

A range of measures designed to approximate the euro area neutral rate are indicating that policy rates are becoming increasingly restrictive, and credit flows within the bloc’s bank-dominated financial system have collapsed, with October’s data showing the biggest 12-month drop in lending to businesses and households since the euro crisis.

12-month change in loans by euro area monetary financial institutions, billions euro

A worsening economy and easing labour markets have not yet triggered a sharp decline in underlying inflation, but headline measures fallen to well within the European Central Bank’s target range, and policymakers are coming under pressure to begin easing. President Lagarde’s protestations – she warned “we should not lower our guard” against inflation risks and claimed officials “did not discuss rate cuts at all” in the year’s final meeting – are falling on deaf ears in the financial markets, especially given that erstwhile hawk Isabel Schnabel earlier noted a “remarkable” drop in prices and called further tightening “rather unlikely”. Swaps markets are assigning high odds to the first reduction coming at the central bank’s March meeting, followed by another five moves over the course of the year.

Fading inflation pressures should boost real household incomes in the months ahead, helping support a stronger-than-anticipated rebound in consumer demand within key European markets. Industrial production levels might eke out a modest improvement if Chinese stimulus spending begins flowing in earnest and global inventory cycles normalize. And as rate expectations fall, financial conditions in the euro area are easing almost as quickly as in the United States. We think this could translate into a snapback in credit demand across the economy. 

Bloomberg financial conditions indices

A gradual recovery in consumer spending is unlikely to fully offset other structural impediments to growth in the euro area. The energy shock unleashed by the Russia-Ukraine war has rendered many heavy manufacturing industries non-viable, and an easing in demand from China will weigh on the export sector for years to come. The lagging impact of this year’s monetary tightening efforts might hollow out activity among the region’s once-thriving middle market businesses. And the bloc’s overall fiscal stance is projected to turn contractionary as Next Generation EU grants fail to compensate for the expiration of remaining pandemic- and energy-related measures.

We think European equities and bond markets will continue to trade at a sharp discount to their US equivalents, helping cap upside in the common currency. After an mid-2024 rally, we expect the exchange rate to turn in an underwhelming performance, ending the year only modestly stronger against the dollar.

Estimated EURUSD Expiration Range by Confidence Interval