Investors are now betting that the ECB’s deposit rate could approach 3% by late 2027, with markets assigning a growing probability to further rate increases after an expected hike in September. The ECB raised rates in June as it responded to inflationary pressures triggered by an energy shock linked to the U.S.-Iran conflict.
According to Reuters, the latest market pricing reflects growing concern that the inflation impact of the conflict could extend beyond higher crude oil prices. Brent crude has been trading above $90 a barrel, while risks surrounding refined fuel supplies, low euro zone gas inventories and the possibility of a prolonged conflict have added to concerns over the inflation outlook.
Markets are pricing an approximately 25% probability of the ECB deposit rate reaching 3% by March 2027 and around a 60% probability by September 2027. A month earlier, investors had seen virtually no chance of the rate reaching 3% by March.
The ECB is widely expected to raise its deposit rate to 2.5% in September. Reuters reported that expectations for additional tightening have strengthened even as oil prices have retreated from a peak of about $120 a barrel reached in April. Physical Brent premiums have also fallen sharply, from around $40 to about $7.
The resilience of rate-hike expectations suggests that investors remain concerned about the broader inflation consequences of the conflict and the potential response from the ECB, even if crude prices continue to decline.
Energy Markets Remain a Key Inflation Risk
The conflict is raising concerns that energy-market disruptions could persist for an extended period, keeping inflation elevated across the eurozone.
Reuters reported that refined fuel markets could remain particularly tight, with refining margins, or crack spreads, elevated for an extended period. Tight supplies of products such as diesel could create additional inflationary pressure even if crude oil prices moderate.
Natural gas is another significant concern for the euro zone. Gas storage levels are at their lowest for this time of year in more than a decade, increasing uncertainty over supplies ahead of winter.
According to Capital Economics, euro zone gas inventories were last at comparable levels in 2021, when European gas prices subsequently climbed above 170 euros. Prices are currently around 65 euros, but the combination of depleted inventories and strong summer demand has increased the risk of renewed price pressure.
Hot weather has also contributed to higher energy consumption, with increased demand for air conditioning adding to pressure on gas and power markets.
Disinflationary Forces Losing Momentum
The inflation outlook is also being shaped by factors beyond the immediate energy shock. Expansionary fiscal policies, increased defence spending, investment related to the green transition and persistent labour-market tightness could make it more difficult for inflation to return quickly to the ECB’s target.
The euro zone economy has meanwhile shown signs of resilience. Reuters reported that business activity data released on Friday indicated that private-sector activity expanded at its fastest pace of the year.
That economic resilience could give policymakers greater scope to maintain or increase borrowing costs if inflation remains above target.
Markets Reassess the Neutral Rate
Expectations for longer-term euro zone interest rates have also moved higher. The five-year euro short-term rate overnight index swap, which is used as an indicator of where markets expect the region’s neutral interest rate to settle, climbed to around 2.85% on Thursday, its highest level since November 2023.
A higher expected neutral rate suggests investors believe monetary policy may need to remain tighter over the longer term than previously anticipated.
Reuters reported that markets are increasingly incorporating the possibility that the conflict could persist through the U.S. midterm elections in November. A prolonged geopolitical crisis would increase the likelihood of sustained energy-market disruption and make the ECB’s inflation challenge more difficult.
For investors, the combination of elevated energy risks, resilient economic activity and fading disinflationary forces is shifting the euro zone interest-rate outlook toward a more restrictive path. If geopolitical tensions remain unresolved and energy prices stay elevated, markets could continue to increase their expectations for ECB rate hikes through 2027.
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