ECB Rate Hike Bets Mount as Energy Risks Cloud Inflation Outlook

Money markets are increasingly pricing in a more aggressive European Central Bank, with traders now wagering that geopolitical tensions will keep inflation pressures stubborn enough to push the key deposit rate to nearly 3% by late 2027.

The ECB is expected to raise rates again in September, following a June hike aimed at containing price pressures triggered by an energy shock from the U.S.-Iran conflict. While oil prices have retreated from their April peak of $120 a barrel to trade above $90, analysts say the risks are broader than crude alone.

Investors point to potential tightness in refined fuel supplies, thin euro zone gas inventories, and a conflict that could extend beyond November's U.S. midterm elections. The market's reaction has been notable: rate hike bets have held firm even as physical Brent premiums collapsed from $40 to $7, suggesting traders remain wary of inflation even if oil prices ease.

Markets now price roughly a 25% chance of the deposit rate reaching 3% by March 2027 and about a 60% chance by September. Just a month ago, there was no pricing for a move to 3% by March.

"The baseline assumption is that a durable Middle East peace deal remains achievable before the U.S. midterm elections," said Henry Cook, senior economist at MUFG. "But if that starts to seem out of reach and energy pricing moves closer towards the ECB's adverse scenario, we could see something more akin to a fully-fledged tightening cycle," he added, mentioning a deposit rate of "at least 3%."

Beyond oil, the natural gas market is also a concern. Storage levels are at their lowest for this time of year in over a decade, partly due to hot weather boosting air conditioning use. Capital Economics notes the last time inventories were this low was in 2021, when prices peaked above €170; they currently sit around €65.

Analysts also see fading disinflationary forces. Expansionary fiscal policy, green-transition investment, defence spending, and persistent labour market tightness are reversing some pre-pandemic trends. The euro zone economy has shown resilience, with business activity growing at its fastest pace this year.

A market gauge of the euro area's neutral rate — the level where monetary policy is expected to settle — reached roughly 2.85% on Thursday, its highest since November 2023. "We could also say that the policy rate market pricing reflects the assumption that the war will continue until November," said Carsten Brzeski, ING's global head of macro research.