Traders More Hawkish Than Central Banks: Betting on Four More ECB Rate Hikes and Five More BoE Hikes, Severely Out of Step with Official Statements

Energy price spikes have reignited inflation concerns, prompting money markets to shift toward more hawkish bets. Swap contracts show the European Central Bank may raise rates four more times by 25 basis points each over the next 12 months, while the Bank of England may hike five times. This stands in sharp contrast to the two central banks' recent cautious rhetoric and underscores the difficulty of predicting how long the Middle East conflict will last and its knock-on effects on inflation. These bets are far removed from the signals policymakers have recently conveyed. After raising rates last week for the second time since the Iran war broke out, the ECB reiterated that it would not pre-commit to further action. Officials at the time believed the market's bet on three hikes was already too aggressive. Economists now expect the ECB to raise rates only one or two more times. The Bank of England has not raised rates this year. Deputy Governor Dave Ramsden said last week that he was comfortable with current policy but acknowledged upside risks. The BoE will hold its rate meeting on Thursday, and the market expects no change. Earlier this year, Governor Andrew Bailey pushed back against market pricing for two hikesless than half of what the market is currently betting on. "This market pricing is completely out of sync with what the Bank of England is telling us," said James Smith, an economist at ING. He believes Bailey may again push back against market pricing, but "these warnings may fall on deaf ears." Markets often overbet on rate hikes or cuts, but the current degree of divergence is unusual. The reason lies in the high uncertainty over how long the Middle East conflict may last and how large its knock-on effects on inflation will be. Energy Shock Ignites Bond Market: Yields Soar, Rate-Hike Bets Heat Up This week's repricing of the rate path followed a fresh surge in energy prices. Natural gas prices jumped to their highest level since 2022, and crude oil futures rose for a second straight day on Tuesday, breaking above $108 a barrel, as a key Saudi pipeline remained offline. As inflation fears stemming from the prolonged conflict spread through the market, short-term government bond yields soared. Two-year German and UK bond yields posted their longest weekly winning streaks in years, while long-term borrowing costs hit their highest levels in decades. "This is an external shock they cannot control," Elias Haddad, head of global market strategy at Brown Brothers Harriman, said of policymakers. "The best thing they can do is ensure the energy shock does not spill over into underlying inflation and inflation expectations." The Bank of England is expected to address rising energy costs at its upcoming rate meeting. Swap contracts imply a 30% probability of a hike, a scenario that was considered highly unlikely just days ago. With no press conference scheduled after the rate decision, traders will scrutinize the wording of the statement. In March, the BoE warned it was "ready to act" against inflation from surging energy prices, prompting markets to rush to price in higher ratesyet no hike has materialized since. "It will be hard for Governor Bailey to be more hawkish than the market," said Moyeen Islam, a strategist at Barclays. Cross-asset strategist Ven Ram believes the ECB, after last week's hike, has reached the upper end of the range its economists estimate as the nominal neutral rate. Three more hikes would push the benchmark rate deep into restrictive territory, giving even some of the more hawkish Governing Council members pause. On the BoE, the strategist also said that even within its policy committee, estimates of the neutral rate vary widely, but Taylor rule-based estimates suggest the bank's policy target rate would be far below the market-expected level of close to 4.75% a year from now. Hedging Demand Heats Up: Volatility Climbs, Traders Aren't Just Betting on Direction Swaps are a gauge of rate expectations, but that market is more complextraders are not just making pure directional bets; some are also hedging against borrowing cost volatility. Market indicators show that expected one-month volatility in UK and European two-year swap rates has risen sharply, though it remains well below the peak reached in March. The situation could change if oil supply is further disrupted. Last week, ECB President Christine Lagarde said euro-area inflation would stay elevated for some time because the price shock from higher energy costs could prove more persistent than expected. Under repeated questioning from reporters, she also acknowledged a divergence with rate market pricing. "The market will do what it does, and we will do what we have to do," she said.