The European Central Bank (ECB) should pay close attention to the risk of inflation staying below its 2% target for a long time. Joint borrowing in Europe for defense could strengthen the euro by creating a new safe asset. Concerns about not hitting the inflation target are rising at the ECB. While data over the summer will provide more clarity, markets currently don’t see this risk. This is seen in the recent rise in German 10-year yields after the last rate cut. This article highlights two main points: growing worry at the ECB about inflation staying low for too long and the potential creation of a common eurozone debt to finance defense projects, which could make the euro more appealing worldwide. Markets expect tightening rather than easing, even after a policy shift in June. German government bonds, typically considered safe, saw their yields rise after the rate cut. This suggests that investors think inflation isn’t falling as much as the ECB fears. Our experience shows that changes like these don’t happen in isolation. Inflation expectations strongly influence future pricing, especially in swaps and futures markets. Traders have been hesitant to predict deeper cuts, and this is justified. Longer-term rates remain high—much higher than expected after a rate cut. This disconnect between short-term policies and long-term market pricing should not be ignored. It seems premature to expect a consistent pattern of further cuts. Additionally, we’ve noticed that Bund trading volumes are influenced by various macro factors, not just ECB actions or inflation reports. This indicates that the market stays alert to upcoming fiscal policies and geopolitical events, which can quickly affect spreads. Then there’s the topic of joint borrowing for defense. If this plan moves forward, a shared euro-area asset could work like US Treasuries, providing a relatively liquid and trusted benchmark. This might lead to increased investment in the region. In this scenario, investment in high-quality credits could increase, which might flatten yield curves and muddle duration signals. Consequently, the short end of the market may attract more attention than usual. Although volatility has decreased since earlier this year, it still exists. In options markets, implied volatility has risen from early May lows, indicating a revaluation is happening. Whether this results from inflation uncertainty or fiscal changes, the key takeaway remains: market conditions are dynamic, and bets in either direction carry risks. Peripheral bonds have reacted calmly, but we are closely monitoring for potential spillover effects. Any signs of disagreement on the joint funding strategy, or hesitation from key fiscal players, could lead to wider spreads, especially in less liquid names. In this context, the appeal of core yields as safe investments strengthens; therefore, options positioning is a valuable guide. The ECB’s comments suggest that worries about falling short of their inflation target do not necessarily mean a series of future cuts are coming. Instead, they may simply be preparing to maintain flexibility. Policymakers seem cautious, and rightly so, as a return to consistent disinflation could complicate the future—especially if the US Federal Reserve continues its current course or even tightens further. We should recognize that rate differentials are important, particularly for cross-currency flows. If the euro is backed by a new safe asset while rate differentials decrease, the currency implications could be sharper than currently anticipated. In the coming weeks, flexibility in positioning is crucial. While forward guidance may remain unclear, market pricing suggests that traders are taking a stance. Currently, that stance does not indicate an expectation of prolonged policy support. The July core inflation report could shift this view only if it significantly deviates from expectations. From the current market structure, forward volatility still leans towards higher rates, reflecting where traders expect terminal rates to settle—especially towards year-end. So, as always, focus on tail risks, not just the center. It is unlikely that the market will stay quiet for much longer.

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