Insights 
VT 
The Euro-area’s preliminary inflation estimate for November stayed near the European Central Bank’s (ECB) target at 2% year-on-year. It is anticipated that inflation will be low in early 2026 but gradually increase through 2027, possibly prompting rate hikes in 2027. The services price inflation rose to 3.5% year-on-year, driven by persistent high levels despite a slight monthly decrease. Lower growth in negotiated wages next year is expected to alleviate some of the pressure on services price inflation.
The labour market remains robust, with the unemployment rate growing slightly to 6.4% in November. Household inflation expectations have increased, bolstering the case for those opposing additional rate cuts without a substantial economic downturn. Despite ECB staff projections and market predictions placing inflation below 2% in coming years, there is anticipation of an upward trend due to easing fiscal policies and stronger economic growth. Gross Domestic Product is projected to rise by 1.5% and 2.0% in 2026 and 2027, respectively. The market does not foresee changes in ECB rates during 2026, aligning with current forecasts. However, there are perceived risks leaning towards rate cuts in the short term and rate hikes as fiscal easing progresses.
European Central Bank’s Inflation Strategy
With November’s inflation hitting the 2.0% target, we see the European Central Bank remaining on hold for the foreseeable future. This stability suggests that options on short-term interest rate futures, like Euribor, will likely trade with lower implied volatility in the coming weeks. Markets are currently pricing in no changes to the 4.00% deposit rate throughout 2026, creating a clear baseline.
However, we see a risk of a dovish surprise early next year, as projections point to inflation dipping below target in the first quarter of 2026. This potential for a rate cut is not fully priced in, suggesting that long positions on interest rate swaps or buying call options on Bund futures could be profitable hedges. The unemployment rate ticking up slightly to 6.4%, while still historically low, provides some ammunition for those at the ECB arguing for easing if growth falters.
Looking further out, the greater risk is skewed towards rate hikes in 2027 as fiscal easing from governments begins to stimulate the economy. Sticky services inflation, which is currently running at a high 3.5%, is a key indicator to watch as it proved difficult to control during the recovery period after 2023. This suggests positioning for a steeper yield curve, perhaps by entering payer swaps dated for late 2026 and 2027.
Labor Market and Economic Growth
We must remember that the labor market remains tight, a persistent feature since the post-pandemic recovery that began back in 2023. Combined with household inflation expectations that have recently started to climb again, the ECB has a strong case to resist any calls for premature rate cuts. This underlying strength is why any dips in inflation early next year might be viewed by the central bank as temporary.
