European stocks suffered their biggest drop in two months! Oil prices broke $100, sounding inflation alarms, and the market bet on four interest rate hikes by the ECB and the Bank of England.

Brent crude oil broke through $100 a barrel for the first time since July, European stock markets were hit hard, inflation expectations rose sharply, and traders immediately increased their bets on significant interest rate hikes by the European Central Bank and the Bank of England.

The Stoxx Europe 600 index closed down 1.41% on Wednesday at 640.4 points, its biggest one-day drop since July. The Eurozone STOXX 50 index, a blue-chip index of the Eurozone, also fell 1.58% to 6311.56 points.

The renewed escalation of the conflict between the US and Iran has driven up oil prices, exacerbating market concerns about persistent inflation and further worsening the volatile pattern in European stock markets since they hit record highs in August.

The interest rate market reacted even more dramatically. Swap pricing indicates that traders currently expect the European Central Bank and the Bank of England to each raise interest rates by about 90 basis points by the end of 2027, meaning that both central banks would need to implement three 25-basis-point rate hikes, with a roughly 60% probability of a fourth hike.

The yield on two-year German government bonds—considered the most sensitive indicator of monetary policy expectations—rose as high as 3.08% on Wednesday, its highest level since June 2024.

Oil prices breaking $100 triggers a shift in market narrative

The escalation of the conflict between the US and Iran caused Brent crude oil to rise above $100 a barrel for the first time since July, becoming the direct trigger for this round of market turmoil.

"$100 a barrel seems to have become a key threshold triggering the market narrative," said Emilie Tetard, a strategist at Natixis CIB.

Europe and the UK are highly dependent on imported oil and gas, making their economies particularly sensitive to soaring energy prices.

Lauren van Biljon, senior portfolio manager at Allspring Global Investments, noted, "Oil prices have returned to above $100, and the UK and Europe are indeed still highly pegged to energy prices." She added that the transmission effect of energy prices on inflation, coupled with the Eurozone's stronger-than-expected economic resilience, has driven the market's "aggressive" pricing in a European Central Bank rate hike.

The European Central Bank is expected to announce an interest rate hike at its policy meeting on Thursday, and Governing Council member Joachim Nagel has clearly signaled this rate increase.

Stocks were under pressure across the board, with building materials and retail sectors leading the decline.

This round of declines affected almost all sectors of the European stock market, with cyclical sectors such as construction and materials, and retail experiencing the largest drops.

The STOXX 600 Construction and Materials Index fell 2.57%, the Retail Index fell 2.56%, the Personal and Household Goods Index fell 2.39%, the Industrial Products and Services Index fell 2.34%, and the Food and Beverage Index fell 2.12%.

The retail sector was pressured partly by individual stocks – fast fashion giant Inditex SA fell 3.6% after reporting first-half results that missed analysts’ expectations.

Among blue-chip stocks, Saint-Gobain of France fell 3.9%, Adyen fell 3.84%, and Rheinmetall of Germany fell 3.75%. The biggest decliners in the STOXX 600 included Auto1 Group (down 6.47%), Rightmove (down 5.02%), and Kering Group (down 4.97%).

The oil and gas sector bucked the trend, closing up 0.26%, with Italy's Eni Group rising 1.91% and Total Energy gaining 0.59%, becoming one of the few blue-chip stocks to record gains.

Analysts: Betting on interest rate hikes may have been excessive.

Despite a sharp rise in market expectations for interest rate hikes, some analysts warn that current swap pricing may have exceeded the central bank's actual policy intentions.

Bank of England Governor Andrew Bailey has recently downplayed the possibility of an imminent interest rate hike. Emma Moriarty, portfolio manager at CG Asset Management, believes that given the weak UK economy, a scenario requiring up to four rate hikes to suppress inflationary shocks is "unlikely" to occur.

van Biljon also agreed that the latest round of bets on a Bank of England rate hike "doesn't seem reasonable."

Market strategist Evelyne Gomez-Liechti said that the market's expectations for interest rate hikes by the European Central Bank and the Bank of England "are both tending to be over-bet."

Bank of America strategists also advised clients to go long on short-term Eurozone bonds, arguing that the ECB's interest rate hikes are overvalued, citing a lack of strong evidence of widespread inflationary pressures and downside risks to the Eurozone economy that will limit the central bank's room for further rate hikes.

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