Traders have intensified their wagers on interest rate increases from the European Central Bank and the Bank of England, driven by surging energy costs that threaten to keep inflation elevated well into the coming year.

Swap markets now indicate that traders anticipate roughly 90 basis points of tightening from the European Central Bank by December 2027, marking the most aggressive pricing in this cycle. This implies policymakers may need to deliver three quarter-point hikes, with a 60% probability of a fourth move. Concurrently, swap pricing suggests the Bank of England is expected to implement a similarly substantial increase, pushing its key rate to the highest level since February 2025.

Both Europe and the UK depend heavily on imported oil, and particularly natural gas, leaving their economies vulnerable to price shocks. With crude trading back above $100 a barrel, concerns over an inflation surge stemming from the Iran conflict are mounting. The European Central Bank is widely anticipated to raise rates at its Thursday meeting, and the shift in swap markets underscores the growing anxiety.

"With oil back above $100, it's clear that the UK and Europe remain highly sensitive to energy prices," said Lauren van Biljon, senior portfolio manager at Allspring Global Investments. "Beyond the knock-on effects of energy on inflation, the euro-area economy's relative resilience may also be prompting the notably aggressive ECB pricing."

Short-dated bond yields across Europe climbed on Wednesday. Germany's two-year yield, which is most sensitive to monetary policy expectations, rose to 3.08%, its highest level since June 2024.

Where to Begin?

Meanwhile, some analysts contend that swap market pricing for hikes through the end of 2027 may be excessive, given that policymakers appear reluctant to tighten repeatedly. While European Central Bank Governing Council member Joachim Nagel has hinted at a possible move on Thursday, he remains cautious about the subsequent policy trajectory. Bank of England Governor Andrew Bailey has also sought to temper expectations for near-term hikes.

"Given the UK's economic weakness, it's unlikely we'll see an inflation shock that would necessitate as many as four rate increases to contain," noted Emma Moriarty, portfolio manager at CG Asset Management. Allspring's van Biljon similarly believes the recent surge in BOE hike bets "doesn't look quite right." Evelyne Gomez-Liechti added that market expectations for the number of rate increases from both the European Central Bank and the Bank of England are likely too high.