Progress in the eurozone... and what remains to be done - June 10, 2025
By suggesting that the eurozone may not need any further interest rate cuts, or only minor ones, the ECB appears fairly optimistic. However, this optimism is not unfounded given the low inflation rate, low unemployment and renewed financial integration.
By lowering its key interest rates again by 25 basis points to 2% for the deposit rate, the ECB is signaling that it has reached a level it considers comfortable, prompting investors to anticipate at least a pause in rate cuts this summer. The ECB's stance in the second half of the year will of course depend on the level of trade tensions between the US and Europe. High tensions would trigger a further rate cut because, unlike in the US, they would push down inflation in Europe. However, the ECB's own projections (Chart 1) show that it currently considers the risk of “lowflation,” i.e., inflation significantly and persistently below 2%, to be very low.
The ECB may be wrong in its relatively optimistic projections, but it must be acknowledged that Ms. Lagarde's self-satisfaction at her press conference was not entirely without foundation. Inflation in the eurozone has indeed returned to normal without any rise in unemployment, which has even reached a historic low of 6.2% of the working population on average in the eurozone (Chart 2). This low level of unemployment is certainly one of the main reasons why the ECB's models assign only a low probability to the “lowflation” scenario in the medium term, even if, in the short term, certain deflationary pressures are at work, such as those linked to the reorientation of Chinese exports towards Europe.
But there is another key area where the ECB can be satisfied. Financial fragmentation – one of the endemic risks in the eurozone that the ECB is monitoring closely – has declined further despite the end of the ECB's interventions in the credit markets (end of QE, etc.). The emblematic long-term interest rate differential between Italy and Germany has even fallen below 100 basis points, and cross-border bank credit flows have been recovering strongly for several quarters. Thus, after collapsing during the euro crisis, the financial integration indicators calculated by the ECB have rebounded strongly, especially since 2023 (Chart 3).
This means both that credit conditions differ relatively little between euro area countries and that financial agents – banks, investment funds, etc. – are no longer hesitating to invest outside their national borders. This revival of cross-border “financial velocity” within the euro area is clearly conducive to growth, especially in the current context of a gradual recovery in bank lending (Chart 4).
Other developments are also helping the euro area. After the euro crisis freed the ECB from the shackles of German monetary philosophy, the crisis in Ukraine and then pressure from the US put an end to its fiscal philosophy. All of these developments are logically fueling a new perspective on Europe among investors, even if the short-term economic outlook remains fragile.
But for Europe – and the euro – to become attractive to the rest of the world in the long term, it will need to move up a gear. The theoretical agenda has been known for a long time: partial mutualization of public debt to create a deep market for Eurobonds, decisive deepening of a single market where non-tariff barriers are still considerable, particularly in services, etc. Given the success of populist and nationalist parties in Europe, we are not holding our breath. However, we note that the Capital Markets Union project launched in 2015 seems to be gaining momentum. And that Olivier Blanchard, former chief economist at the IMF, is talking about Eurobonds again... In any case, the narrative seems to be shifting.
In our flexible and diversified portfolios, we remain well invested in eurozone financials and in the theme of European domestic reflation.