Markets price growing odds ECB will hike rates to 3% by late 2027

Money markets are increasingly wagering on a hawkish European Central Bank, with traders pricing a growing chance that the deposit rate could reach 3% by late 2027 as the U.S.-Iran war sustains energy-driven inflation pressures across the euro zone.

Rate Hike Expectations Accelerate

Markets now price a roughly 25% chance of the ECB deposit rate reaching 3% by March 2027 and about a 60% chance by September 2027, according to Reuters. Just a month ago, traders saw no chance of a move to 3% by March. The ECB is expected to raise rates in September after tightening in June, which would bring the deposit rate to 2.5%.reuters

Notably, rate hike bets have held up even as oil pulled back from a peak of $120 hit in April and physical Brent premiums collapsed from $40 to $7, suggesting traders remain worried about inflation regardless of crude prices.reuters

"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," said MUFG senior economist Henry Cook, referencing the prospect of a durable Middle East peace deal before the U.S. midterm elections in November.reuters

Energy Risks and Fading Disinflationary Forces

Analysts warn that the conflict could weigh on energy markets long-term. Mark Dowding, chief investment officer at BlueBay Fixed Income, said "crack spreads will remain elevated for the foreseeable future, with the markets for refined products far tighter than is the case for crude".reuters

Euro area natural gas storage levels sit at their lowest for this time of year in over a decade, with Capital Economics noting that the last time inventories were close to this level was in 2021, when prices peaked above €170. Gas is currently trading around €65.reuters

Beyond energy, expansionary fiscal policy, green-transition investment, defence spending, and persistent labour market tightness are reversing disinflationary forces seen before the pandemic. The five-year euro short-term rate overnight index swap, a proxy for the euro zone's neutral rate, reached roughly 2.85% on Thursday, its highest since November 2023.reuters

Consumer Expectations Offer Slight Relief

In a modest counterpoint, an ECB survey published Friday showed euro-area consumers' one-year inflation expectations edged down to 2.9% in July from 3% in June, while the three-year gauge fell to 2.7% from 2.8%, according to Bloomberg. Separately, ECB Governing Council member Mārtiņš Kazāks said the central bank is "well placed to act if needed" to return inflation to its 2% target.bloomberg+1

ING's global head of macro research Carsten Brzeski offered a summary of current market sentiment: "We could also say that the market pricing reflects the assumption that the war will continue until November".reuters