TD Securities’ macro team expects the European Central Bank to stick with a measured tightening cycle, with a final 25bp rise in December that would take the deposit rate to 2.75%, a level it characterises as mildly restrictive. The bank keeps a bullish EUR/USD year-end forecast and has expressed that view through a 3m risk reversal, positioning against the broader-based USD rally.
Market-derived pricing implies a more extended path. OIS markets are pricing about 31bp of ECB tightening by end-2026, and then close to 100bp cumulatively by end-2027, which would put a terminal rate near 3.5%. That sits well above the 2.5% neutral rate referenced by several ECB policymakers, setting up a gap between current rate expectations and the bank’s projection.
Final ECB Hike and Market Expectations
We expect the European Central Bank to implement one final 25-basis-point rate hike this December, bringing the key deposit rate to 2.75%. Recent inflation data shows Eurozone consumer price growth hovering around 2.2%, suggesting that economic pressures are stabilizing enough to allow a pause after this final move. This means derivative traders should prepare for a shift, as current market pricing aggressively overestimates how much higher the central bank will actually go.
Right now, Overnight Index Swap markets are pricing in nearly 31 basis points of tightening by the end of this year and almost 100 basis points by the end of 2027. This aggressive pricing implies a terminal rate of nearly 3.5%, which sits far above the 2.5% neutral rate estimated by several policymakers. Because we believe the central bank will not validate these extreme market expectations, we expect a downward adjustment in yield expectations very soon.
Currency Options Strategy and EUR/USD Outlook
In the currency options space, we recommend fading the recent broad-based U.S. dollar rally by utilizing three-month EUR/USD risk reversals. With the Euro currently trading near the 1.11 level against the dollar, options sentiment is heavily skewed toward dollar strength, making contrarian euro call options relatively cheap. As policymakers begin to push back against the market’s aggressive rate hike pricing, this currency pair is highly likely to rise toward our year-end targets.
