The euro area economy has proved more resilient than Deutsche Bank expected, but the hard part may be ahead. In a research note titled "The Good, the Bad and the Ugly," economists Mark Wall, Clemente Delucia and Yacine Rouimi organise the outlook around three questions: whether growth can hold up, where the European Central Bank will stop raising rates, and whether fiscal pressures will destabilise sovereign bond markets.
Growth that surprised to the upside
The good news is genuine. Activity indicators have improved and there are early signs of a new investment cycle taking hold across the currency bloc. The euro area has absorbed the latest energy price shock, driven by gas markets, more convincingly than Deutsche Bank's own forecasts had allowed for.
That resilience matters because the energy shock was supposed to be the event that knocked the recovery off course. Higher gas prices feed through industrial costs, squeeze household budgets and depress output in energy-intensive sectors. Instead, the latest data suggest the euro area has found a way to keep expanding, albeit at a modest pace.
The improvement is not uniform. Activity indicators can be volatile, and early signs of an investment cycle do not guarantee follow-through. Deutsche Bank's economists note that higher gas prices, a widening AI trade deficit and persistent weaknesses in European competitiveness still argue for caution. The AI trade deficit reflects the fact that European firms are importing AI-related technology, hardware and services from the United States and Asia faster than they are exporting their own, a structural drain that compounds existing productivity challenges.
The ECB's narrowing room for manoeuvre
The bad news is monetary policy. Deutsche Bank expects the ECB to raise its deposit rate to 2.50% at its September 2026 meeting, a move that would continue the tightening cycle that has already pushed borrowing costs well above the zero and negative rates that prevailed for much of the previous decade.
The more important question is where the cycle ends. Deutsche Bank puts the probability of a further increase to 2.75% as a meaningful risk, while 3.00% would probably cross into restrictive territory, meaning rates high enough to actively slow the economy rather than merely normalise financial conditions.
The distinction between neutral and restrictive matters enormously for borrowers, from Italian small businesses to French homebuyers. If the deposit rate settles at 2.50%, the ECB can plausibly argue it has brought policy back to a level that neither stimulates nor constrains growth. If it reaches 3.00%, the central bank is deliberately trying to slow demand, with all the second-order consequences that entails for employment, investment and government debt servicing costs.
Fiscal risk concentrates on France
The ugly part of the picture is fiscal. European fiscal risks are rising as higher funding costs collide with elevated debt levels and a crowded election calendar. Several member states face the awkward combination of paying more to borrow, needing to fund transitions in energy and digital infrastructure, and answering to voters who may not reward fiscal discipline at the ballot box.
France stands out as the principal vulnerability. The country carries a large stock of public debt, faces persistent deficits and has a political system that can make coherent budgetary strategy difficult to sustain. When Deutsche Bank identifies France rather than Italy or Spain as the main fiscal risk, it is a signal that the usual assumptions about where euro area stress originates may be shifting.
Buffers that could hold
The picture is not uniformly negative. Deutsche Bank points to three important buffers. First, stronger digital investment across the euro area suggests that some of the capital spending needed to address the competitiveness gap is already under way. Second, European banks are well capitalised, which reduces the risk that a period of tighter policy triggers a financial crisis. Third, European policy backstops, including the instruments developed during the pandemic and the subsequent energy crisis, provide a framework for responding to sovereign stress if it materialises.
Those backstops matter because they change the calculus for bond markets. During the euro area debt crisis of the early 2010s, the absence of credible collective instruments meant that worries about one country's solvency could rapidly spread to others. The creation of common instruments, even if they remain politically contentious, gives the ECB and national authorities tools they did not have a decade ago.
A harder second stage
Deutsche Bank's central argument is that the euro area has cleared the first hurdle, absorbing the energy shock, but faces a more demanding set of challenges ahead. The next stage will be shaped by two forces running in parallel: the ECB continuing to tighten monetary policy, and European governments entering a politically sensitive budget season where spending commitments and electoral pressures collide with higher debt service costs.
The interaction between monetary and fiscal policy is where the risk lies. Higher ECB rates increase the cost of servicing government debt. Governments that need to borrow more to fund investment or social spending find themselves paying more to do so, which widens deficits and can spook bond markets. That dynamic is particularly acute in France, where the debt stock is large and the political capacity for fiscal consolidation is uncertain.
The AI trade deficit adds a newer concern. As European companies invest in artificial intelligence capabilities, much of that spending flows to American and Asian technology providers. The resulting deficit in AI-related trade is a drag on the current account and raises questions about whether Europe is building or merely buying its way into the next technological cycle.
What the autumn will test
The coming months will test both the resilience thesis and the fiscal risk thesis simultaneously. The ECB's September rate decision will set the tone for the autumn. If the deposit rate reaches 2.50% as Deutsche Bank expects, the focus shifts immediately to whether one more increase follows. Governments, meanwhile, will be drafting budgets against a backdrop of higher borrowing costs and, in several countries, approaching elections.
People mentioned
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Clemente Delucia
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Yacine Rouimi
Organisations
Deutsche Bank · European Central Bank
