In recent times,the United States has faced a surge in financial pressures,with indications that the Federal Reserve is nearing the end of its tightening cycle.This situation could deepen the economic divergence between the U.S.and other parts of the world,particularly Europe.A significant question for the Eurozone is whether its economic cycle and monetary policy will align with or diverge from that of the U.S.,and how long any differences will persist.

Despite the looming risks that financial pressures might pose to European economic growth,expectations remain for supportive policies to emerge this year,alongside robust fundamentals for consumers and businesses.There are increasing signs that inflation in Europe is not only strong but also becoming entrenched.It is within this framework that we assert that the European Central Bank (ECB) may need to maintain a tighter monetary stance for longer than the market currently anticipates.The key supporting arguments for this position are outlined below.

First,U.S.financial pressures present new downside risks to Eurozone growth.

As of now,the impact on European consumer and business confidence—and the financing costs for European banks—has been relatively limited.However,these two potential risks cannot be overlooked.A dip in consumer and business confidence could slow down expected economic growth rates from recent surveys,while rising financing costs could intensify the already sluggish credit growth within the private sector.To illustrate,the annualized growth rate of private sector credit in Europe has slipped from a pace of 6-7% of GDP last summer to merely 1% in the first quarter of 2023.

Secondly,European banks appear to be demonstrating a greater resilience compared to their U.S.counterparts.

While the risks stemming from rising financial pressures warrant attention,it should be noted that European banks are relatively robust—especially concerning their liabilities.This situation contrasts with the U.S.landscape,where money market funds exert considerable competitive pressure on deposits.On the asset side of their balance sheets,the ECB has been a major purchaser of government bonds,absorbing the entirety of net government bond issuance over the past decade.

Moreover,the relatively supportive policy environment alongside solid consumer and business fundamentals underpins growth in the Eurozone.

Despite a tightening monetary policy in Europe,the measures still remain modest,with fiscal policy continuing to be accommodative.The fundamentals for consumers and businesses are particularly strong.Nominal income growth has reached historical highs,and as we anticipate a drop in overall inflation rates to around 3% by the end of this year,real income growth is expected to accelerate.Currently,unemployment rates are at record lows,while corporate profitability is surging,with profit margins reaching their highest levels since before the global financial crisis.Clearly,without accounting for these potential downside risks,the fundamentals suggest that momentum is stronger than the growth forecasts put forth by the ECB.

Furthermore,there are increasing signs that inflation remains robust and increasingly entrenched.

Despite the Eurozone's core inflation peaking at 5.7% in March,our forecasts indicate that due to the ongoing strong increases in core service prices and record wage growth,we project core inflation rates for 2023 and 2024 to be about 0.5-0.6 percentage points higher than the ECB’s projections.Although energy prices have recently softened,consumer inflation expectations rebounded in March to nearly 3%,suggesting that inflation is becoming more stubborn.Compared to the U.S.,data from the Eurozone remains strikingly high,with both core inflation and wage growth trending upwards.We anticipate that Eurozone inflation will surpass that in the U.S.and exceed the average rate among G7 nations in the years to come.

The ECB may extend the duration of its interest rate hikes,with market pricing exhibiting upward risks.

In its May meeting,the ECB decided to slow the pace of interest rate increases to 25 basis points,reflecting sensitivity to the recent slowdown in credit growth amid financial pressures.However,its own projections align with a terminal rate of up to 4.0%,which suggests that the risks surrounding these predictions are tilted towards the upside.

As financial pressures escalate,there could be non-policy-induced tightening effects.Should adverse conditions not materialize,the ECB may continue its normalization of interest rates in the autumn.Furthermore,real interest rates indicate that the tightening measures required by the ECB carry upward risks.As shown in recent analyses,after adjusting for mid-term consumer inflation expectations,real interest rates stand at just 0.35%—significantly lower than the equivalent rate of 2% in the U.S.

In summary,investors should brace themselves for ongoing divergences,which will have varying impacts on asset prices across the Eurozone and other regions.