• Dax has been off to a flying start this year, despite the ECB lifting rates.
• However, the German economy has been showing signs of weakness.
• Does the rally have legs?

On Thursday, the European central bank lifted its key deposit rate to 3.5%. This marked the eighth consecutive increase and the highest level in more than two decades – in line with economists’ expectations.

Rates up, German Economy down

The steep rate hikes secured economic recessions in Germany and the Eurozone as Europe’s top economy shrunk for two back-to-back quarters.

Further signs of weaknesses emerged from the building up of inventories for some companies, such as Zalando, indicating retail weakness, which could spell trouble for German companies.

Not to mention that German Manufacturing PMIs have been crashing,

However, despite all those headwinds, the Dax continues to make new highs.

Dax flying high

The Dax has been in a steep uptrend since the start of the European Central Bank (ECB) rate hiking cycle. Germany’s largest index is up over 37% since the September lows of last year.

Will the rally nosedive, or will it continue its impressive run? To a large degree, the answer lies in the path of interest rates, a function of inflation. Hence, the next question becomes what the markets are expecting. One more rate hike, and that’s it?

However, this rosy scenario may not play out as the ECB looks far behind the curve, and unlike in the US, where actual rates have entered positive territory, Eurozone real rates are still deeply negative at -2.6%.

Not only that but core inflation, despite tumbling more than expected at 5.3% year-over-year for May, is still way off the ECB target of 2%. ECB President Lagarde said, “There is no clear evidence that underlying inflation has peaked” after the latest inflation print. And rightfully so. Labour costs in Germany continue to rise way ahead of expectation, giving fear to wage pull inflation.

Stronger earnings have underpinned the market’s resilience, contrary to some economic sentiment indicators such as the Zew Indicator, which further dipped to -10 in June from -9.4 in the prior month.

Lastly, earnings recession may be another major threat the markets might have underestimated. Most positive catalysts look already priced in, and the P/E ratios may need to adjust to factor in the potential weaker macro and earnings outlook, especially if the services inflation continues to show signs of persistence and turns out to be stickier than expected.

All in all, expectations seem quite rosy, hoping for the immaculate soft-landing scenario to materialize.