Weekly focus – Budget risks replace war concerns, for now

The conflict between Israel and Iran has deescalated and a truce seems to hold. This has calmed market fears that Iran might disrupt global energy supplies by hindering traffic through the Strait of Hormuz, and the oil price has declined around 15% since last week's peak, taking it down to levels similar to before Israel's surprise airstrike. Financial markets in general responded relatively calmly to escalation of the conflict, and hence the reaction to the de-escalation has also not been large. Most notably, the USD has come under renewed pressure, also driven by a media story that President Trump might consider replacing Jerome Powell as head of the Federal Reserve before his term ends next year. Trump has very clearly stated his wish for lower interest rates, while Powell this week repeated his view that it is better to wait and see what effect tariffs will have on inflation.

NATO member countries agreed to target defence spending of 3.5% of GDP in 2035, with an additional 1.5% of GDP for defence-and-security related spending. It is unclear how much of the latter will mean higher spending than what already spent, but the former target alone will - if reached - means an additional 1.5% of GDP in spending in the euro area. If a large part of this is financed with new borrowing, as seems likely, it should have a modestly positive effect on European GDP growth in the short term. Over the 10-year implementation period, we expect the impact on GDP to be minimal and the increased demand for defence instead to result in higher interest rates, all else equal. Together with the outlook for easier fiscal policy also in the US, we believe that risks are tilted to the upside for longer bond yields.

In economic data, Euro area PMI was slightly to the weak side. It looks like GDP growth declined but remained positive in Q2. The first June inflation data, for Spain and France, was if anything a little higher than expected. US PMI remains somewhat above European, indicating that GDP rebounded in Q2 after the decline in Q1. Consumer confidence disappointed in June and the share of Americans who think jobs are plentiful continues to decline, which has historically been a fairly good indicator of a weakening labour market. As inflation expectations are also easing, sentiment supports the outlook for lower interest rates from the Fed.

In the coming weeks, attention is likely to turn back to US tariffs, as the various postponements of tariff hikes are set to expire, creating deadlines for negotiations. Also, the US budget process for 2026 should be finalised including tax cuts. Economic data, especially for the labour market, should be key in terms of the timing of coming US rate cuts. We will also monitor the ECB's upcoming Sintra Forum (with our colleague Piet Christiansen speaking) for signs of cracks in the internal consensus that rates are at an appropriate level now, although it will take a lot to make a cut at the July monetary policy meeting likely. In China, we expect to see a lift to the economy as US exports rebound, and domestic stimulus increases.

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