Eurozone headline inflation rose to 3.2% in May from 3% in April, while core inflation increased to 2.5% from 2.2%. The May core reading was above both ABN AMRO and consensus forecasts of 2.4%. Energy was described as the main driver, and food inflation eased. Services inflation accounted for the main upside surprise, rising by 0.5 percentage points to 3.5%, compared with an expectation of 3.3%.
With the flash estimate lacking a full breakdown, country releases were used to infer that transportation services were the primary source of the move, with airfares linked to higher jet fuel costs. Jet fuel was said to have risen at double the magnitude of Brent crude at its peak after the Iran conflict began. ABN AMRO expects inflation to remain above the European Central Bank’s 2% target through the rest of the year, and still anticipates two ECB rate hikes by July.
ECB Rate Hike Outlook Strengthened By Services Inflation
We see the latest May inflation figures as a clear signal for traders. The surprise jump in services inflation firms up the case for European Central Bank rate hikes. In the coming weeks, positioning for higher short-term interest rates should be the primary focus.
Eurostat’s recent flash estimate confirmed headline inflation rose to 3.2%, with services inflation hitting 3.5%, the highest in over a year. This data strongly supports our expectation of two more rate increases by July. The market is now pricing in a near 90% probability of a 25 basis point hike at the next meeting, up from 70% last week.
Trading Strategies Amid Rising Rate Expectations
Traders should consider paying fixed on short-dated euro interest rate swaps to bet on rising rates. Selling futures contracts on the three-month EURIBOR rate is another direct way to position for the expected ECB action. These instruments are sensitive to near-term policy shifts, making them ideal for the current environment.
We saw a similar pattern in the 2022-2023 hiking cycle, where stubborn services inflation forced the ECB to act more aggressively than initially expected. That period saw front-end yields rise significantly, and we anticipate a similar, albeit smaller, move now. History suggests the ECB will not hesitate to act when core components like services remain elevated.
The uncertainty over whether this inflation is from a narrow set of factors, like airfares, creates an opportunity in volatility markets. We recommend looking at buying call options on the VSTOXX index, the main gauge of European equity volatility. This provides a hedge and can profit if the market becomes nervous about the ECB’s path.
These rate hike expectations should also provide support for the euro, especially as other central banks like the U.S. Federal Reserve appear to be on hold. Online data shows that speculative positioning in the euro has already turned positive for the first time in three months. We believe establishing long EUR/USD positions through futures or call options is a compelling secondary trade.
