The return of oil prices to $100 has sparked inflation concerns, prompting traders to significantly increase their bets on interest rate hikes by the European and Bank of England.

As international energy prices continue to soar, increasing market concerns about persistently high inflation over the next year, traders are significantly raising their bets on further interest rate hikes by the European Central Bank (ECB) and the Bank of England (BOE). The interest rate swap market currently expects both central banks to implement cumulative rate hikes of about 90 basis points by the end of 2027. However, some investors and Wall Street institutions believe that the market may have overestimated the extent of future rate increases. The latest interest rate swap pricing indicates that the market currently expects the ECB to raise rates by about 90 basis points by December 2027, the highest level since the onset of the current monetary tightening cycle. This implies that the ECB is expected to implement at least three 25-basis-point hikes during this period, with the market also pricing in about a 60% probability of a fourth hike. Expectations for rate hikes by the Bank of England have also significantly intensified. The swap market anticipates that the cumulative rate hikes by the BOE will also approach 90 basis points, and if this expectation materializes, the UK's benchmark interest rate will rise to its highest level since February 2025. The primary factor driving the market's rapid shift toward a hawkish stance is the surge in energy prices. Europe and the UK are highly dependent on imported oil, particularly natural gas, making their economies more sensitive to rising international energy prices compared to energy-producing countries like the United States. As the war in Iran escalates energy supply risks, international oil prices have once again surpassed $100 per barrel, leading investors to worry that a new round of energy shocks could further increase inflation via transportation, electricity, production costs, and consumer prices. Lauren van Biljon, a senior portfolio manager at Allspring Global Investments, noted that oil prices have climbed back to $100, and the economies and inflation rates in the UK and Europe remain closely linked to energy prices. In addition to the energy price shock, the stronger-than-previously-expected performance of the Eurozone economy has also been a significant reason for the market's increased expectations for ECB rate hikes. If the economy can withstand higher interest rates, the ECB's room for maneuver in controlling inflation will correspondingly expand. The market generally expects the ECB to raise rates at its monetary policy meeting on Thursday. ECB Governing Council member Joachim Nagel has previously signaled the possibility of a rate hike this week, although he has remained cautious about the subsequent policy path. The sharp rise in market rate hike expectations has quickly transmitted to the European bond market. On Wednesday, yields on European short-term government bonds generally increased, with the two-year German government bond yieldmost sensitive to changes in monetary policysurging to 3.08%, the highest level since June 2024. However, as the market begins to bet on multiple future rate hikes by both the ECB and the BOE, some investors feel that current pricing has become overly aggressive. While ECB officials have shown a high level of openness to further tightening of monetary policy recently, they remain relatively cautious about several consecutive rate hikes. Nagel hinted at the possibility of a rate hike on Thursday but did not make any firm commitments regarding sustained tightening afterward. At the BOE, Governor Andrew Bailey has also sought to downplay the likelihood of another rate hike in the near future. Emma Moriarty, a portfolio manager at CG Asset Management, believes that considering the current weakness in the UK economy, the possibility of a severe inflation shock necessitating up to four rate hikes by the BOE to control inflation is not high. Van Biljon similarly believes that the rapid rise in BOE rate hike expectations "does not seem reasonable." Market participant Evelyne Gomez-Liechti stated that investors may be "misguidedly leaning towards betting too heavily on excessive hikes" from both the ECB and the BOE. Bank of America strategists have also advised investors to maintain caution regarding the hawkish expectations currently priced into the short-end interest rates in the Eurozone. The bank believes that there is still a lack of sufficient evidence that rising energy prices have evolved into broader and more persistent inflationary pressures, and the increasing economic headwinds facing the Eurozone in the future will also limit the extent to which the ECB can raise rates.