Traders are bracing for an increasingly hawkish ECB

By Stefano Rebaudo

Aug 21 (Reuters) - Money markets are bracing for an increasingly hawkish European Central Bank, wagering that geopolitical tensions will complicate its inflation battle and keep price pressures stubborn enough to lift the key deposit rate to almost 3% by late 2027.

The ECB is expected to raise rates in September, after tightening in June to contain price pressures unleashed by the U.S.-Iran war-induced energy shock.

Analysts say it's not just elevated oil prices, trading at over $90 a barrel, that are keeping investors on edge, but also the risk of tighter supplies of refined fuels, thin euro zone gas inventories and a conflict that could drag on beyond November's U.S. midterm elections.

That's playing out in rates markets where in addition to an anticipated September rate increase that would take the depo rate to 2.5%, bets on additional tightening are gaining momentum.

Markets price a roughly 25% chance of the ECB deposit rate reaching 3% by March 2027 and an about 60% chance by September.

Just a month ago they priced no chance of a move to 3% by March.

Analysts said it's notable that rate hike bets held up even as oil pulled back from a peak of $120 hit in April and physical Brent premiums collapsed from $40 to $7, which suggests that traders remained worried about inflation and the ECB reaction even if oil retreats.

“The baseline assumption is that a durable Middle East peace deal remains achievable before the U.S. midterm elections (in November),” said MUFG senior economist Henry Cook.

“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 to “at least 3%.”

ENERGY SHOCK

Investors warned that the war could weigh on the energy market long-term, fuelling inflation.

"Crack spreads will remain elevated for the foreseeable future, with the markets for refined products far tighter than is the case for crude," said Mark Dowding, chief investment officer at BlueBay Fixed Income, mentioning also damage related to the war in Ukraine.

The crack spread measures the margin between refined products such as diesel and crude oil, and is often used as an indicator of oil-related inflation pressures.

Euro area inflation is also driven by the natural gas market, with storage levels at the lowest for this time of year in over a decade amid expectations the region will fall short of its goal before the winter, due partly to hot weather increasing use of appliances such as air conditioning units to cool down.

Capital Economics said the last time inventories were close to this level was in 2021, when prices reached a peak of over €170. They are currently at around €65.

FADING DEFLATIONARY FORCES

Inflation could prove stickier than expected as expansionary fiscal policy, green-transition investment, defence spending and persistent labour market tightness reverse some of the disinflationary forces seen before the pandemic.

The euro zone economy has also proved resilient, with data on Friday showing business activity growing at its fastest pace this year.

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. The neutral rate is the level at which monetary policy is expected to settle in the medium term.

“We could also say that the (policy rate) market pricing reflects the assumption that the war will continue until November," said ING's global head of macro research Carsten Brzeski.

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(Reporting by Stefano Rebaudo; Editing by Dhara Ranasinghe and Toby Chopra)