The Euro area’s initial inflation estimate for November remained close to the European Central Bank’s (ECB) goal of 2% year-on-year. Inflation is expected to stay low in early 2026 but is likely to rise gradually through 2027, which might lead to interest rate hikes in 2027. Services price inflation increased to 3.5% year-on-year, driven by consistently high figures, despite a slight monthly drop. A slower growth in negotiated wages next year should help ease some of the pressure on service price inflation. The job market is strong, with unemployment rising slightly to 6.4% in November. Expectations for household inflation have increased, strengthening the argument against further rate cuts unless there is a major economic downturn. Even though ECB staff and market forecasts predict inflation will drop below 2% in the coming years, there is an expectation of rising inflation due to loosening fiscal policies and stronger economic growth. The Gross Domestic Product is projected to grow by 1.5% in 2026 and 2.0% in 2027. The market does not expect any changes in ECB rates throughout 2026, in line with current predictions. However, there are perceived risks leaning toward rate cuts in the short term and increases as fiscal easing progresses.

European Central Bank’s Inflation Strategy

With November’s inflation at 2.0%, the European Central Bank is likely to maintain its current stance for the foreseeable future. This stability suggests that options on short-term interest rate futures, like Euribor, will probably show lower implied volatility in the upcoming weeks. Markets are currently projecting no changes to the 4.00% deposit rate throughout 2026, establishing a clear baseline. Nevertheless, there is a risk of a dovish surprise early next year, as forecasts indicate inflation may dip below the target in the first quarter of 2026. This possibility of a rate cut isn’t fully reflected in the market, suggesting that holding long positions on interest rate swaps or buying call options on Bund futures could be smart hedges. Despite the unemployment rate inching up to 6.4%, which is still historically low, it provides some support for those at the ECB advocating for easing measures if growth slows. Looking ahead, the greater risk may shift towards rate hikes in 2027, as government fiscal easing begins to boost the economy. Persistent services inflation, currently at 3.5%, will be a crucial indicator to monitor, as it proved challenging to control after the recovery began in 2023. This suggests positioning for a steeper yield curve by entering payer swaps dated for late 2026 and 2027.

Labor Market and Economic Growth

It’s important to remember that the labor market remains tight, a constant since the post-pandemic recovery that started in 2023. Combined with a rise in household inflation expectations, the ECB has solid reasons to resist any pressures for early rate cuts. This underlying strength makes it likely that any dips in inflation early next year will be seen by the central bank as temporary. Create your live VT Markets account and start trading now.

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