By Stefano Rebaudo
April 13 (Reuters) – Money market traders expect the European Central Bank to lean hawkish, keeping rates higher for longer and offering little prospect of easing even in the medium term as the energy shock from the ongoing Iran war is seen persisting.
The U.S. military said it will begin a blockade of all maritime traffic entering and exiting Iranian ports and coastal areas on Monday, after weekend talks failed nL6N40V09S to reach a deal to end the war.
The surge in oil and gas prices since the start of the conflict has prompted traders to price up to an 80% chance of a hike at the ECB’s April meeting, and almost four hikes in 2026. This is a stark contrast to expectations that prevailed before the war began — a roughly 40% chance of a cut this year.
As a result, two-year yields — the most sensitive to shifts in expectations for rates and inflation — have risen sharply for most countries.
If rates stay higher for longer, financial conditions will tighten, growth will slow and debt‑servicing costs for governments will rise, increasing fiscal strain especially for highly indebted euro zone countries.
Germany’s 10-year yields are now above 3% and the premia of Italian and French yields over Bunds hit their highest level in 10 and 5 months, respectively, in late March.
ECB SEEN TO ACT MORE SWIFTLY THAN IN 2022
Analysts said the ECB underestimated inflation in 2022 and would likely act earlier this time to head off second-round effects, which refer to inflation becoming self-sustaining as initial pricing behaviour feeds into wages and prices.
Concerns about long-term effects continue to weigh, with longer-term bond yields also rising, as EU nS8N3YN09T and ECB officials warned of lasting consequences nL6N40J0MR from damage to energy infrastructure in the region, even if an immediate peace deal was reached.
“If the Iran conflict persists, the ECB might ultimately deliver more than two hikes and might even consider 50-bp steps,” Reinhard Cluse, chief European economist at UBS, said.
Markets are pricing in rates rising over the next 15 months, with traders expecting a key rate of around 2.6%, from slightly below 2% before the war started.
The euro short-term rate (ESTR) 5-year overnight index swap (OIS), seen as a barometer of the medium-term monetary policy outlook and loosely used as a market-implied gauge of the neutral rate, has climbed, remaining significantly above 2.4%, its highest level seen in the previous 19 months.
“With this high level of uncertainty, the focus is primarily on inflation,” Luca Pennarola, senior economist at BNP Paribas, said. “Definitely we can see ECB doing more than 75 bps (of rate hikes, if the backdrop worsens). I don’t see a limit to that, to be honest.”
“I think markets are underpricing the adverse effects on growth from higher oil prices,” said Carsten Brzeski, head of macro strategy at ING, referring to the medium-term policy rate outlook.
Brzeski expects two rate hikes by June and a cut in December if the Strait of Hormuz doesn’t reopen before summer, and no change in rates if it opens before summer.
Euro short-term rate forwards, which closely track oil prices, recorded the biggest monthly rise ever as Iran effectively closed the Strait of Hormuz, a chokepoint for roughly a fifth nL1N40H074 of global oil and gas supplies.
A market gauge of inflation expectations showed that investors keep expecting ECB to tame price pressures, seen slightly above 2% in the medium term.
“It is, in part, the credibility that the ECB has gained after the Russia-Ukraine crisis: they have demonstrated that they were able to bring inflation back to 2%,” said Silvia Ardagna, head of European economic research at Barclays.
“But it is also the fact that we are all operating under the assumption that the Strait of Hormuz will reopen,” she added.
(Reporting by Stefano Rebaudo; Editing by Amanda Cooper and Janane Venkatraman)
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