The Eurozone is at risk of experiencing stagflation if the crisis in the Middle East continues. This situation poses a global threat and is not confined to the Eurozone alone.

Economic stability hinges on developments in the Middle East, with the Strait of Hormuz being an area of high concern. Monitoring of the situation is ongoing, as it impacts both European and worldwide economies.

Oil Market Pressures

Earlier economic indicators have already shown signs of disinflation across core Eurozone countries, but we now see a scenario where oil market pressures could reverse that trend swiftly. Brent crude has repeatedly edged higher in recent weeks, driven not by domestic supply issues but by apprehensions over shipping routes and potential retaliatory moves from regional actors. If flows through the Strait of Hormuz see prolonged disruption, we should expect to see a direct upward push on energy costs across the single currency bloc.

Lagarde acknowledged last month that any external cost shocks might require a reevaluation of the current monetary policy stance. Although rates have remained on hold, inflation expectations could rise regardless of what the European Central Bank signals publicly. That divergence between messaging and market pricing may create opportunities along longer-tenor instruments, as yield curves begin to reflect more realistic expectations about commodity-driven inflation rather than demand-led growth.

Traders should not draw conclusions based on short-term FX volatility alone. We noted earlier this week that option-implied volatilities on euro pairs have climbed, but not yet to levels consistent with panic. Instead, there’s a steady repricing underway. What this tells us is that contingency hedging is increasing, likely by firms exposed to cross-border trade and energy-sensitive sectors.

Schaeuble pointed out two weeks ago that Euro-area core capital spending may retrench if operational costs remain unpredictable. Credit markets reacted swiftly, with spreads on mid-grade corporate debt widening beyond one-year averages. The follow-on is a downtick in activity around corporate bond derivatives. Fewer issuers are hedging at recent volumes, instead waiting to see if energy premiums stabilise. That wait-and-see approach, however, limits liquidity for certain contracts in the meantime.

Inflation and Interest Rate Expectations

We’re now watching for how long European policymakers will tolerate external inflation pressures without responding. Because the core economy is still showing low growth and moderate demand, the European Central Bank is boxed in. Any tightening may further suppress output, while inaction risks undermining price stability. In this setting, most of the market is preparing for wider rate volatility. The shift toward trading interest rate options rather than directional positions reflects that almost everyone expects more price uncertainty.

Looking forward, inflation swaps can reveal market sentiment before official economic releases do. We’ve already observed a modest uptick in two-year breakevens, which reflects hedging demand rather than pure expectations. That pattern usually anticipates upward surprises in CPI data three to six weeks ahead. So if correlations hold, the hedging now being executed suggests traders are already preparing for energy-induced pressure on consumer prices by early next quarter.

For positioning, the divergence in monetary response between central banks now presents opportunities in cross-currency basis products. The Federal Reserve, for example, has more room to stay elevated for longer, given the resilience of US service-led inflation. That spread between path expectations makes relative value ideas on euro-dollar swaps more attractive than outright directional bets.

We prefer to interpret the pricing shifts not as speculative overshoots, but as reasonable alignments with the logistics and political risks at play. With uncertainty centred around supply chokepoints rather than macroeconomic data, the usual indicators lose some of their usefulness. In turn, momentum in derivatives will come from changes in realised volatility–rather than purely from sentiment shifts.

Our view remains that optionality has become the dominant strategy in the near term. With so many event-driven variables contributing to energy prices, outright long or short positions offer poor risk-adjusted returns. Instead, the better move is to use calendar spreads and skew builds to gain exposure to volatility compression or extension, rather than direction itself. That way, positioning remains adaptable while still allowing responsiveness to sharp moves if they occur.

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