ECB policymakers believe that no additional interest rate reductions are required to achieve the 2% inflation target. Current economic projections predict an inflation undershoot over the next two years.
Borrowing costs in the euro zone are expected to remain unchanged, assuming no new major economic shocks occur. December will bring a chance for reassessment, with updated quarterly forecasts extending to 2028.
Short Term Rate Expectations
With the European Central Bank signaling a firm pause, we see short-term rate expectations solidifying. August’s core inflation reading of 1.8% is clearly not low enough to force their hand, suggesting the current policy rate will be the anchor for now. This view is being priced into markets, with forward swaps showing minimal chance of a rate cut before the end of the year.
For the next several weeks, this creates an environment that seems favorable for selling volatility. Strategies like short straddles on EURIBOR futures could be effective, as implied volatility will likely decline given the bank’s clear intention to wait. We saw a similar dynamic with the US Federal Reserve’s “higher for longer” stance through much of 2024, where range-bound trading dominated between policy meetings.
However, the ECB has clearly signposted the December meeting as the next major decision point. This suggests we should consider buying longer-dated options that capture this event, as volatility will almost certainly increase in late November. A calendar spread, selling a near-term option to fund the purchase of one expiring after the December decision, could be an effective way to position for this.
Main Risk to Stable Outlook
The main risk to this stable outlook is a significant downturn, which the bank has acknowledged. We will be closely watching leading indicators like the German IFO Business Climate index and Eurozone PMI releases for any sharp deterioration. If the manufacturing PMI, which sits at a weak but stable 48.5, were to fall back towards the low 40s seen during the 2023 slowdown, it would challenge the bank’s patient stance.
This policy divergence should also provide a floor for the euro, particularly against currencies whose central banks are more likely to ease. The EUR/USD exchange rate, which has been hovering around 1.09, may find support as interest rate differentials stop moving against it. We can use options to express a view of a stable or slightly appreciating euro, perhaps by selling out-of-the-money EUR puts.
