Inflation panic rekindled; expectations for two ECB rate hikes this year have been fully priced in!

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Soaring energy prices are reshaping European interest rate trading. As oil prices continue to surge and natural gas spikes trigger renewed concerns about inflation, the market is quickly raising expectations for tighter policy rates from the European Central Bank and the Bank of England, with the short end of bonds bearing the brunt.

According to Bloomberg, the interest rate swap market has now fully priced in two rate hikes by the European Central Bank this year, each by 25 basis points, with the first hike expected as early as June. Last week, the market only expected one hike.

The abrupt shift in interest rate expectations was immediately transmitted to the bond market. Eurozone government bonds fell, with short-term bonds leading the decline. The two-year German government bond yield rose by 14 basis points to 2.45%, and the two-year Italian government bond yield jumped 22 basis points to 2.76%.

The UK market has also seen a turn. Money markets increased bets on future Bank of England rate hikes, factoring in about 15 basis points of tightening by 2026; before the US-Iran conflict, the market still expected the Bank of England to cut rates twice this year, each by 25 basis points.

Oil prices break $100, natural gas soars, energy shock becomes trigger for renewed inflation

The intensity of this round of energy price increases has exceeded earlier expectations. On Monday, natural gas prices surged up to 30% in a single day, and last week's weekly gain was the largest since the energy crisis. Meanwhile, international oil prices once neared $120 per barrel.

ING Research's calculations last week provided a quantitative reference: For every 10% rise in oil prices, overall UK inflation will rise by about 0.1 percentage points; for every 10% rise in natural gas prices, the inflation boost is about 0.15 percentage points.

Since February 27, UK natural gas futures prices have risen by about 105%. This means that natural gas alone could have a considerable potential boost to UK inflation.

ECB policy expectations reverse sharply, two rate hikes this year fully priced in

The energy price shock has significantly changed the outlook for eurozone monetary policy. According to Bloomberg, the interest rate swap market now fully prices in two ECB rate hikes of 25 basis points each this year, whereas last Friday, the market only expected one rate hike.

The timing of the first rate hike is now priced as early as this June, meaning the ECB’s window to restart its tightening cycle has been significantly shortened.

The violent reaction in the eurozone bond market confirms the extent of market concerns about the inflation outlook. Short-term government bonds bore the brunt, and German and Italian two-year bond yields — more sensitive to monetary policy shifts — both registered significant single-day increases.

Italy’s yield spread with Germany widened even more, reflecting market caution about fiscal pressure in eurozone peripheral countries.

UK’s fragile inflation base, risks of central bank policy shift cannot be ignored

On the UK side, the market is even more sensitive to the energy shock. According to Bloomberg, traders have now priced in about 15 basis points of tightening by the Bank of England this year, and the expected policy path has fundamentally reversed compared to ten days ago.

Bloomberg cited analysts saying, the UK’s inflation situation is less stable than the eurozone's and faces risks of falling back into a price spiral.

However, there are also factors limiting excessive pricing of the Bank of England's rate hike path. The UK labor market has already shown weakness, and the unemployment rate is at a five-year high. If geopolitical conflict further develops into a growth shock, companies will find it harder to pass on rising costs to consumers.

In addition, UK financial conditions have already tightened spontaneously, with major lenders raising mortgage rates ahead of time, partly substituting for the effect of proactive central bank rate hikes.

Risk warning and disclaimerThe market poses risks, and investment should be cautious. This article does not constitute personal investment advice, nor does it take into account individual users' special investment goals, financial situations, or needs. Users should consider whether any opinions, views, or conclusions in this article fit their specific situation. Investing based on this article is at one’s own risk. ```