Euro area headline inflation decreased to 1.7% year-on-year in January, falling short of the target, with core inflation at 2.2%. Despite this, the European Central Bank (ECB) maintained the deposit rate at 2.00%, as anticipated.
Danske Bank notes that the January report offered a dovish signal due to a weaker-than-expected service inflation figure of 0.15% month-on-month. ECB President Lagarde emphasised positive economic factors like low unemployment and minimised concerns over the strengthened Euro and inflation undershoot.
Risks to Inflation
The report states risks to inflation are on the rise in the US and balanced in the euro area. Danske Bank’s baseline scenario assumes no changes in ECB rates over the forecast period.
Looking back at the situation in early 2025, we saw the European Central Bank hold its deposit rate at 2.00% despite headline inflation falling below target to 1.7%. That period of patience ended as price pressures re-accelerated through the second half of the year. Now, with the latest January 2026 data showing headline inflation at a persistent 2.8%, the environment has completely shifted.
The ECB’s dovish stance from last year is a distant memory, with the deposit rate now standing at 2.75% after three subsequent hikes. Market focus is now on the terminal rate, as the “balanced” inflation risks mentioned by officials in 2025 clearly tilted to the upside. Overnight index swaps are currently pricing in a greater than 70% probability of another 25 basis point hike by the April meeting.
Implied Volatility and Interest Rate Strategy
This uncertainty has kept implied volatility elevated, with 3-month at-the-money options on EUR/USD trading near 8.5%, well above the averages seen in early 2025. For traders who believe the central bank is nearing the end of its tightening cycle, selling strangles could be an attractive strategy to collect premium. Conversely, those anticipating a hawkish surprise in response to stubborn services inflation should consider buying puts on Euribor futures.
Given the ECB’s more aggressive path, interest rate swap markets offer opportunities to position for future policy. We see value in paying fixed on short-term swaps, such as the 2-year tenor, to speculate on the market pricing in an even higher peak rate. This contrasts sharply with early 2025, when the debate was centered on potential cuts rather than further hikes.
The Euro has strengthened considerably since last year, with EUR/USD now trading near 1.1050 as rate differentials moved in its favour. Traders should use options to manage their currency exposure around key data releases and upcoming ECB meetings. We believe buying short-dated EUR/USD call spreads offers a cost-effective way to position for further upside if upcoming wage growth data surprises.
