- Ukraine: A fragile ceasefire ahead? The most likely scenario (40% probability) would see Russia halting offensives but retaining control of occupied areas, and Ukraine seeking strong security guarantees from the US and Europe. Some Western sanctions are likely to be reduced, but gas sanctions would persist. Europe is likely to increase defense spending by at least 0.5pp, getting close to 3% of GDP on average from 2.2% currently. The multiplier on boosting Eurozone growth can reach 0.5 if EU procurement rules are reinstated. In this scenario, inflation is projected to decrease by -0.5pp from the current 1.9%, with oil prices likely to decrease by 5-10% and gas prices likely to drop by 25%, targeting 37 EUR/MWh. Hence, Eurozone GDP growth could be +0.5pp higher than our current forecast of +1% in 2025. However, if Ukraine and Europe reject the US-brokered deal with Russia, hostilities could resume, the US would likely withdraw military assistance to Ukraine and leave NATO and Europe would face a deteriorated growth outlook amid higher gas prices. Markets are holding onto hope, already positioned for the best-case scenario, with possible gains of 0 to +5pps and a total return of +10%. German year-end 2025 rates are anticipated at 2%. The EUR/USD exchange rate is expected to stabilize at 1.10 and corporate credit spreads could narrow by 0 to -5bps, reaching around 85bps.
- How can Europe close its defense spending gap? While defense spending in the EU is expected to rise by EUR140bn annually (from 2.2% to 3% of GDP), doubling current military capacities in two years would require spending 4% of GDP, translating to EUR320bn annually, with half of it spent on equipment, from the current 25%. With Germany’s debt brake likely remaining in place after the election and a EU-wide resistance to raising taxes amid a weak economic outlook, EU debt funding is the most likely short-term source of funding, especially with EUR300bn in unused NGEU funds available until 2026. However, EU debt has already surged through previous programs such as the ESM, SURE and NGEU, reaching EUR840bn by the end of 2024. The EU as an issuer has already surpassed all states except France in net debt issuance, which has contributed to rising interest rates. This will translate into debt-servicing costs rising to 20% of the EU commission’s budget by 2026 from virtually zero pre-Covid, raising concerns about long-term fiscal sustainability and potentially further rising yields if military spending is not eventually funded via tax hikes or spending cuts.
- An ECB rate cut is certain, but Europe’s defense scenarios will shape the terminal rate. At its next meeting on 6 March, we expect the ECB to cut the deposit rate to 2.5% as widely expected by markets. However, what happens next remains less clear. Our baseline scenario, which now also covers an end to the war in Ukraine, still sees the terminal rate at 2.0% to be reached in June and quantitative tightening (QT) to continue. However, in the scenario of significantly higher fiscal deficits due to defense spending, we see a terminal rate of 1.5% and an earlier stop of QT, with a risk of returning to Quantitative Easing (QE) mode.