Bad Moon Rising

• Red flags are emerging for the US economy. This is a downside risk for USD.
• German election result was largely in line with polls and is EUR supportive. DAX futures are up over 1%.
• New Zealand retail sales overshoot expectations in Q4, validating RBNZ cautious easing guidance.

Check-out our Drivers for the Week Ahead for an in-depth look at what markets are facing this week.

USD bounced off its lowest level since December 10, 2024. Treasury yields are heavy near recent lows with Fed funds futures still pricing-in 45bps of cuts by year-end. US equity futures are slightly higher after getting hammered Friday.

Red flags are emerging for the US economy. Private sector activity came close to stalling in February. The composite PMI unexpectedly plunged to a 17-month low at 50.4 and points to annualized GDP growth of just 0.6% over Q1 vs. 2.3% in Q4. The slump was driven by the first contraction in the services sector in 25 months. According to S&P Global “service providers commonly linked the downturn in activity and worsening new orders growth to political uncertainty, notably in relation to federal spending cuts and potential policy impacts on economic growth and inflation outlooks.”

Another month or two of poor US economic data would deliver a blow to the US exceptionalism narrative and is a downside risk for USD. Second-tier US economic data are due today: January Chicago Fed business index (1:30pm London), and Dallas Fed manufacturing index (3:30pm London).

EUROZONE

A new chancellor in town. Friedrich Merz is set to be new German chancellor as his center-right Christian Democratic Union (CDU) has captured the highest proportion of votes in Sunday’s election. The CDU/CSU bloc won 28.6% of the votes, equivalent to 208 seats in the 630 seats Bundestag. The populist Alternative for Germany (AfD), led by Alice Weidel, came second with 20.8% share of the votes (152 seats). Chancellor Olaf Scholz’s center-left Social Democratic Party (SPD) placed third with 16.4% (120 seats).

Merz said he wanted to form a coalition within the next two months. His party’s solid win paves the way for a two-party coalition. The most likely option is a “grand coalition” with the SPD as Merz has repeatedly ruled out forming a government with AfD. But in politics promises are made of glass.

The election result was in line with polls and is EUR supportive. A two-party coalition will have a good mandate to push through long overdue fiscal reforms more effectively than under a three-party collation. Moreover, AfD does not have enough seats in the Bundestag to block constitutional changes like relaxing the debt brake - which restricts annual structural deficits to 0.35% of GDP in any fiscal year. Any change to the constitution requires two-thirds majorities in both houses of parliament.

Different shades of ECB doves. ECB policy maker Pierre Wunsch said he was “relatively comfortable” with market expectations of 2% rates by year-end “give or take 50 basis points.” He also cautioned “we must not sleepwalk to 2% without thinking about it.” Meanwhile, ECB policymaker Francois Villeroy de Galhau said on Saturday that the ECB policy rate “could be at 2% this coming summer.” The ECB has scope to deliver on rate cut expectations because the Eurozone growth outlook Is sluggish, and the disinflationary process is well on track.

Germany’s February IFO Business index is up next (9:00am London). The headline is expected to recover 0.7pts to 85.8, current assessment is expected to rise 0.2pts to 86.3, and expectations is expected to rise 0.8pts to 85.0. Risks are skewed to the upside given the better-than-expected improvement in the German PMI and ZEW investor economic sentiment survey.

UK

Three Bank of England (BOE) speakers take the spotlight today. Deputy Governor Clare Lombardelli (9:00am London), Deputy Governor Dave Ramsden (1:15pm London), and Swati Dhingra (6:00pm London). Dhingra was one of the two dissents (Catherine Mann was the other) that voted for a 50bps cut in February and so her comments will clearly lean dovish. The BOE is expected to pause easing at its March 20 meeting. Over the next 12 months, the swaps market is pricing in 50bps of easing and small odds of an additional 25bps cut.

NEW ZEALAND

NZD/USD edge up a little before paring back gains. New Zealand Q4 retail sales data was stronger than anticipated. The total volume of retail sales increased 0.9% q/q (consensus: 0.5%) vs. 0% in Q3 (revised up from -0.1%), with growth across most industries. The data supports the RBNZ’s guidance for a more gradual pace of easing. The RBNZ has penciled-in another 75bps of easing over the next 12 months that would see the policy rate bottom at 3.00%. This seems about right.

ISRAEL

Bank of Israel meets today and is expected to keep rates steady at 4.50% (2:00pm London). At the last meeting January 6, the bank also kept rates steady, and Governor Yaron said that “To lower rates now would be similar to trying to take out a fire using fuel. Because labor shortages are a major obstacle, lowering rates will increase demand without increasing supply, so it will just bring on price rises.” However, it was ultimately a dovish hold as the updated rate path saw the policy rate at 4.00-4.25% in Q4 2025 vs. 4.5% seen in 3Q 2025 at the October 9 meeting. It appears that the bank is teeing up the start of an easing cycle late this year. The swaps market is pricing in 25bps of easing over the next six months followed by another 50bps over the subsequent six months that would see the policy rate bottom near 3.75%.