Euro area inflation decreased to 1.7% year-on-year in January, which is below the target, while core inflation stood at 2.2%. The European Central Bank (ECB) kept the deposit rate steady at 2.00%, as expected.
Danske Bank pointed out that the January report sent a dovish signal due to service inflation rising only 0.15% month-on-month. ECB President Lagarde highlighted positive economic signs like low unemployment and eased worries over a strong Euro and lower inflation.
Inflation Risks
The report indicates that inflation risks are increasing in the US but are balanced in the euro area. Danske Bank’s basic forecast assumes that ECB rates will remain unchanged over the forecasting period.
Looking back to early 2025, the ECB held its deposit rate at 2.00%, even as headline inflation dipped to 1.7%. However, this patience ended when price pressures increased in the second half of the year. By January 2026, headline inflation had risen to 2.8%, changing the situation completely.
The ECB’s dovish position from last year now feels far away, with the deposit rate rising to 2.75% after three rate hikes. Market attention is now on the terminal rate, as the previously “balanced” inflation risks have shifted upwards. Currently, overnight index swaps indicate over a 70% chance of another 25 basis point hike by the April meeting.
Volatility and Interest Rate Strategy
This uncertainty has kept implied volatility high, with 3-month options on EUR/USD trading around 8.5%, significantly above early 2025 averages. Traders who think the central bank is nearing the end of its tightening cycle might find selling strangles appealing to earn premiums. On the other hand, those expecting a hawkish move due to stubborn service inflation should consider buying puts on Euribor futures.
With the ECB adopting a more aggressive stance, interest rate swap markets present opportunities for future positioning. We see potential in paying fixed on short-term swaps, like the 2-year tenor, to bet on even higher peak rates. This is a stark contrast to early 2025 when discussions focused on possible cuts rather than more hikes.
The Euro has gained significantly since last year, with EUR/USD trading near 1.1050 due to favorable rate differentials. Traders should use options to manage their currency exposure around key data and upcoming ECB meetings. We suggest buying short-dated EUR/USD call spreads as a cost-effective way to benefit from potential upside if upcoming wage growth data surprises.
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