Investors adopt "higher for longer" view on ECB rates

By Stefano Rebaudo and Linda Pasquini

(Reuters) -Investors are increasingly pricing in a "higher for longer" interest rate environment in the euro zone, with a potential cut in March seen as a temporary blip before borrowing rates climb back above 2%.

A number of market-based measures of rate expectations indicate that investors are growing less concerned about the deflationary impact of tariffs following the recent trade deal between the United States and the European Union.

They're also confident that a sharp increase in fiscal spending in Germany will boost the economy, thereby reducing the need for more rate cuts in the longer term.

Several investment banks, including Goldman Sachs, have revised their forecasts, now anticipating that the European Central Bank has ended its current easing cycle.

While trade risks could still weigh on growth and inflation, these banks believe the ECB, which offered an upbeat assessment of the euro zone economy after its latest meeting, is likely to hold rates at 2% for the foreseeable future.

Erring on the side of caution, markets are pricing in the risk of a pick up in deflationary pressure early next year if tariff negotiations falter, which is showing up as an implied ECB rate cut in March.

In the meantime, the euro has risen by nearly 3% this month as investors increasingly expect the U.S. Federal Reserve to resume rate cuts in September, while the ECB stays put.

"Higher for longer" was a narrative that dominated markets in 2022 and 2023 as central banks grappled with stubborn inflation stemming from the COVID pandemic and Russia's invasion of Ukraine.

Here are some of the market indicators that reflect its return.

ESTR FORWARDS EDGE TOWARDS 2%

Forward contracts on the ECB's official overnight benchmark interest rate, the euro short-term rate (ESTR), imply around a 60% chance of a 25 basis point rate cut by March, and a deposit rate of 1.92% in December 2026.

This reflects traders' assumptions about the likely path for monetary policy.

“In the short term... there is the potential of inflation undershooting. It's a bit of Trump. It's a bit of economic weakness,” said Carsten Brzeski, global head of macro research at ING.

“Our view is that inflation will remain structurally above 2% in the coming years, driven by fiscal spending and the restructuring of supply chains, which will increase costs for companies,” he said.

He added that policy rates could reach the upper bound of the ECB's official 1.75% to 2.25% range for the neutral rate - that which is neither accommodative nor restrictive - and shift into tightening territory if required.

EURO 5-YEAR ESTR INDEX SWAP HOVERS JUST ABOVE 2%

The euro short-term rate (ESTR) 5-year overnight index swap (OIS) is seen as a barometer of the medium-term monetary policy outlook and can be loosely used as a market-implied gauge of the neutral rate.

The swap rate hit a high of 2.406% in early March, when Germany agreed on the biggest overhaul to its fiscal spending in decades, and has since fallen to around 2.12%, having traded above the 2% mark consistently for the last six weeks.

“We're a bit more negative on growth than everyone else and a bit more worried about inflation than everyone else,” said Lyn Graham-Taylor, senior rates strategist at Rabobank.

“But we've literally no change for the deposit rate out till the end of 2027,” he added.

EURIBOR RATES SEEN ON A MILD UPTREND IN 2027

The Euro Interbank Offered Rate reflects the average rate at which major European banks lend unsecured funds to one another.

The Euribor rate also captures some credit risk because of the involvement of banks. The curve mirrors that of ESTR forwards, so it also suggests rates could dip modestly by March before rising above 2% again into 2027.

Paul Hollingsworth, head of developed markets economics at BNP Paribas, believes the ECB's next move will be to hike rates in the fourth quarter of next year.

“I see the rate hike as a recalibration within the neutral range...as the balance of data and risks shifts from the drag of tariffs toward a more positive impulse driven by fiscal policy,” he said.

(Reporting by Stefano Rebaudo, additional reporting by Linda Pasquini, editing by Amanda Cooper and Kirsten Donovan)