ECB policymakers feel that no further interest rate cuts are needed to reach the 2% inflation target. Current economic forecasts suggest inflation will be below this target for the next two years. Borrowing costs in the euro zone are expected to stay steady unless there are major economic changes. In December, there will be a chance to reassess the situation, with updated quarterly forecasts extending to 2028.

Short Term Rate Expectations

With the European Central Bank (ECB) choosing to pause, short-term rate expectations are becoming more stable. The core inflation rate from August stands at 1.8%, which is not low enough to prompt action, indicating that the current policy rate will likely remain in place for now. Markets reflect this expectation, with forward swaps showing little chance of a rate cut before the year ends. Over the next few weeks, this environment may be good for selling volatility. Strategies like short straddles on EURIBOR futures could work well, as implied volatility is likely to drop with the bank’s decision to wait. A similar situation occurred with the US Federal Reserve’s “higher for longer” approach in 2024, where trading stayed within a range between policy meetings. The ECB has highlighted the December meeting as the next key decision point. This suggests we should consider buying long-term options to take advantage of this event, as volatility is likely to rise in late November. A calendar spread, where we sell a near-term option to fund the purchase of one that expires after the December meeting, might be a smart strategy.

Main Risk to Stable Outlook

The biggest threat to this stable outlook is a significant economic downturn, which the bank has noted. We’ll keep a close eye on leading indicators, such as the German IFO Business Climate index and Eurozone PMI reports, for any signs of sharp decline. If the manufacturing PMI, currently weak but stable at 48.5, drops toward the low 40s, as it did during the 2023 slowdown, it could make the bank rethink its cautious approach. This difference in policy should provide support for the euro, especially against currencies whose central banks are more likely to ease. The EUR/USD exchange rate, currently around 1.09, may find stability as interest rate differences stop shifting against it. We can use options to express a view that the euro will remain stable or even appreciate slightly, possibly by selling out-of-the-money EUR puts. Create your live VT Markets account and start trading now.

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