Eurozone outlook — early 2026: a cautious normalization
Quick take
– Inflation is easing but remains above pre-pandemic norms (core CPI ~2.6% y/y), keeping policy vigilance high.
– Growth is soft: Q4 2025 GDP +0.8% y/y (+0.2% q/q) and unemployment about 6.5%, pointing to a protracted, uneven recovery.
– Markets have repriced: 10‑year German bund ≈1.60%, 10‑year OAT ≈1.95%, and Italian BTP‑Bund ≈185 bps. Investors favor short duration and inflation‑protected assets.
– Probability snapshot: markets price ~55% odds of ≥50 bps ECB easing within 12 months; 18% chance of stagflationary stress; 28% chance of renewed upward bond repricing (10‑year bund ≥2.00%).
Lead: what’s happening and why it matters
The eurozone has moved into a selective normalization phase. Inflation is cooling, yet services and wage dynamics keep underlying pressure above the old “normal.” Growth is modest at best, and liquidity and policy expectations are the main drivers of asset prices. That mix raises a familiar trade-off: lower near‑term recession risk but persistent upside inflation surprises that could lift long yields and compress central-bank room for easing.
The numbers that matter (scannable)
– Inflation: headline CPI 2.4% y/y; core CPI (ex food & energy) 2.6% y/y.
– Growth & labour: Q4 2025 GDP +0.8% y/y (+0.2% q/q); unemployment ~6.5%.
– PMIs: manufacturing ~49.5 (slightly contracting); services ~52 (still expansionary).
– Rates & spreads: 10‑yr Bund ≈1.60%; 10‑yr OAT ≈1.95%; 10‑yr BTP‑Bund ≈185 bps.
– Flows & liquidity: Eurosystem liquidity down an estimated €200–300bn y/y; equity inflows ~€40bn in H1 2025, fixed‑income ETF outflows ~€25bn.
– Volatility & pricing: VSTOXX proxy (1‑month € vol) ~22%; markets pricing ~50 bps of ECB easing by end‑2026.
Macro backdrop: why market pricing looks like this
Central banks have shifted to data dependence. Policy rates remain higher than pre‑inflation cycles, and forward guidance points to easing only if inflation retreats more convincingly. With fiscal space limited in several member states and global demand softer, the eurozone faces constrained countercyclical options. That explains why investors are trimming duration risk yet still buying inflation protection: they want to hedge both a growth slowdown and the chance that services inflation stays sticky.
Key variables to watch (the trigger set)
– Services inflation and wages: sustained core CPI above ~2.5% for successive months or wage growth >3.5% y/y would materially reduce the odds of near‑term ECB cuts.
– Growth momentum: two quarters with <0.1% q/q growth increases downside risk to corporate earnings and bank asset quality.
- Sovereign flows: a net foreign demand swing of >€50bn out of eurozone bonds in a single quarter would lift long yields independent of policy talk.
– External shocks: sharp moves in US rates, energy prices, or China demand can quickly alter term premia and funding costs.
How markets might react (scenarios and sensitivities)
– Inflation surprise: a 25 bp rise in breakevens (higher inflation expectations) with real yields flat tends to raise 10‑yr Bund yields by ~10–12 bps; bigger breakeven shocks steepen term premia more markedly.
– Growth shock: a 5% hit to expected corporate EBITDA historically widens IG spreads ~25–35 bps and HY spreads ~70–90 bps.
– US spillover: a 100 bp rise in US 10‑yr often lifts eurozone 10‑yrs by ~40–60 bps via term‑premium and funding channels; added Italian widening (another 100 bps) could increase bank funding costs ~25–40 bps and cut sector earnings ~6–9% over 12 months.
Sector implications (practical effects)
– Sovereigns & rates: core issuers benefit from safe‑haven demand, but peripheral spreads are vulnerable to liquidity turns and fiscal headlines.
– Banks: higher short rates can boost NIMs, yet falling growth or wider sovereign spreads hurt asset quality and capital buffers.
– Credit & corporate: higher yields and tighter funding increase refinancing stress for lower‑rated firms; issuance windows may narrow.
– Real economy: capex remains hesitant; housing demand diverges across markets as affordability pressures bite.
Probabilities and the central forecast
– Markets currently assign ~55% probability of cumulative ECB easing ≥50 bps within a year.
– Stagflation (two quarters <0.2% q/q growth + core CPI >2.5%) is priced at ~18%.
– A renewed upward repricing (10‑yr Bund ≥2.00%) carries ~28% probability.
Central numeric projection
– 10‑yr German bund: central estimate 1.25% by Q4 2026; 68% confidence interval: 0.95%–1.55%.
– This reflects market pricing for roughly 50 bps of expected ECB easing, near‑term GDP momentum of ~0.3–0.6% for 2026, and core inflation around 2.4–2.7% y/y.
What investors and policy teams should do now
– Track sequential, not just headline, reads for services inflation, wages and sovereign flows—small persistent deviations matter.
– Use liquidity and cross‑border funding metrics as early warning indicators for rapid repricing.
– Stress test portfolios for the twin risks of an inflation surprise (steeper term premia) and a growth shock (wider credit spreads and weaker bank earnings).
– Keep allocations flexible: short duration and inflation‑linked instruments offer asymmetric protection; equity exposures should tilt toward cash‑flow resilient sectors if upside inflation risk rises. Markets are neither fully pricing a soft landing nor assuming runaway inflation. That ambiguity explains higher volatility and selective demand for duration protection. Monitor services inflation, wages, sovereign demand and incoming central‑bank communication—those four signals will likely determine whether policy eases smoothly, yields drift higher, or volatility spikes. Note: this is a scenario framework for risk management and market interpretation, not investment advice.