Key facts
- Money markets are anticipating a more hawkish European Central Bank.
- Traders are betting that geopolitical tensions will keep price pressures high.
- The ECB is expected to raise rates in September, with further tightening bets gaining momentum.
- Markets are pricing in a significant chance of the deposit rate reaching 3% by late 2027.
- Elevated oil prices, tight refined fuel supplies, and low euro zone gas inventories are contributing to inflation concerns.
- Analysts suggest that persistent labor market tightness and increased spending could reverse disinflationary forces.
Money markets are anticipating a more hawkish stance from the European Central Bank, with traders betting that geopolitical tensions will complicate its inflation battle and keep price pressures stubborn enough to lift the key deposit rate to almost 3% by late 2027. The ECB is expected to raise rates in September, following a June tightening, to contain price pressures exacerbated by energy shocks.
Analysts note that elevated oil prices, trading above $90 a barrel, along with risks of tighter refined fuel supplies and low euro zone gas inventories, are keeping investors on edge. These factors are reflected in rates markets, where bets on additional tightening beyond the anticipated September rate increase are gaining momentum. Markets currently price a roughly 25% chance of the ECB deposit rate reaching 3% by March 2027 and a 60% chance by September 2027, a notable shift from just a month ago when no chance of a move to 3% by March was priced.
Traders' concerns about inflation and the ECB's reaction persist even as oil prices have retreated from their April peak. MUFG senior economist Henry Cook stated that while a Middle East peace deal before the U.S. midterm elections is the baseline assumption, a failure to achieve this could lead to a more significant tightening cycle, with the deposit rate potentially reaching at least 3%.
Investors warn that the ongoing conflict could have long-term impacts on the energy market, fueling inflation. Crack spreads, an indicator of oil-related inflation pressures, are expected to remain elevated due to tighter markets for refined products compared to crude oil. The euro area's inflation is also influenced by the natural gas market, with storage levels at their lowest for this time of year in over a decade, partly due to hot weather increasing demand for cooling.
Furthermore, inflation could prove more persistent as expansionary fiscal policy, green-transition investments, defense spending, and a tight labor market reverse pre-pandemic disinflationary forces. The euro zone economy has shown resilience, with business activity growing at its fastest pace this year. The five-year euro short-term rate overnight index swap, a proxy for the euro zone's neutral rate, has reached its highest level since November 2023.