The Eurozone faces the possibility of stagflation if the Middle Eastern crisis continues, posing a global threat that extends beyond the Eurozone. Economic stability depends heavily on what happens in the Middle East, especially in the Strait of Hormuz. We are closely monitoring the situation because it affects both Europe and the world economy.

Oil Market Pressures

Recent economic data show signs of disinflation in key Eurozone countries. However, oil market pressures could quickly reverse this trend. Brent crude prices have risen in recent weeks, not due to local supply issues, but because of concerns over shipping routes and potential retaliation from regional players. If disruptions continue in the Strait of Hormuz, we can expect a sharp increase in energy costs across the Eurozone. Last month, Lagarde noted that any external cost shocks may lead to a reassessment of current monetary policy. While interest rates remain stable, inflation expectations could still rise, regardless of the European Central Bank’s public messages. This disconnect between what the bank communicates and what markets expect might create opportunities for longer-term investments, as yield curves respond more realistically to commodity-driven inflation rather than growth-driven demand. Traders should not only rely on short-term FX fluctuations for conclusions. Earlier this week, we observed that option-implied volatilities on euro currency pairs have increased, yet not to panic levels. Instead, a consistent repricing is happening. This indicates that businesses exposed to international trade and energy-dependent sectors are increasing their hedging strategies. Two weeks ago, Schaeuble warned that core capital spending in the Eurozone might decrease if operational costs remain unpredictable. Credit markets reacted quickly, widening spreads on mid-grade corporate debt beyond one-year averages. This led to reduced activity in corporate bond derivatives, with fewer issuers hedging at recent volumes as they wait for energy premiums to stabilize. However, this cautious approach limits liquidity for certain contracts.

Inflation and Interest Rate Expectations

We are now watching how long European policymakers will endure external inflation pressures without taking action. With the core economy showing low growth and moderate demand, the European Central Bank finds itself in a difficult position. Tightening rates could suppress output further, while inaction raises risks for price stability. The market is gearing up for increased rate volatility, reflecting the expectation of more price uncertainty. Looking ahead, inflation swaps can indicate market sentiment before official economic reports are released. We have seen a slight increase in two-year breakevens, driven by hedging demand rather than straightforward expectations. This trend often predicts upward surprises in CPI data three to six weeks in advance. If this pattern holds, the current hedging suggests that traders are already bracing for energy-induced pressure on consumer prices in the next quarter. The differing monetary policies of central banks now create opportunities in cross-currency basis products. The Federal Reserve, for instance, has more flexibility to maintain high rates longer due to the stability of US service-led inflation. This difference in expectations makes relative value trades on euro-dollar swaps more appealing than outright directional bets. We interpret the pricing changes not as speculative errors but as reasonable adjustments to the logistical and political risks involved. With uncertainty revolving around supply disruptions rather than macroeconomic data, traditional indicators become less reliable. Consequently, momentum in derivatives will depend more on actual volatility changes than sentiment shifts. Our view is that optionality has become the primary strategy for the near future. Given the many event-driven factors affecting energy prices, outright long or short positions provide poor risk-adjusted returns. Instead, using calendar spreads and skew builds to capitalize on volatility changes is a better approach. This positioning allows for adaptability while remaining responsive to sharp market moves. Create your live VT Markets account and start trading now.

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