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Investors are increasingly pricing in a “higher for longer” interest rate environment in the euro zone, with a potential cut in March seen as a temporary blip before borrowing rates climb back above 2%.
A number of market-based measures of rate expectations indicate that investors are growing less concerned about the deflationary impact of tariffs following the recent trade deal between the United States and the European Union.
They’re also confident that a sharp increase in fiscal spending in Germany will boost the economy, thereby reducing the need for more rate cuts in the longer term.
Several investment banks, including Goldman Sachs, have revised their forecasts, now anticipating that the European Central Bank has ended its current easing cycle.
While trade risks could still weigh on growth and inflation, these banks believe the ECB, which offered an upbeat assessment of the euro zone economy after its latest meeting, is likely to hold rates at 2% for the foreseeable future.
Erring on the side of caution, markets are pricing in the risk of a pick up in deflationary pressure early next year if tariff negotiations falter, which is showing up as an implied ECB rate cut in March.
In the meantime, the euro has risen by nearly 3% this month as investors increasingly expect the U.S. Federal Reserve to resume rate cuts in September, while the ECB stays put. Forward contracts on the ECB’s official overnight benchmark interest rate, the euro short-term rate (ESTR), imply around a 60% chance of a 25 basis point rate cut by March, and a deposit rate of 1.92% in December 2026.
The euro short-term rate (ESTR) 5-year overnight index swap (OIS) is seen as a barometer of the medium-term monetary policy outlook and can be loosely used as a market-implied gauge of the neutral rate.
The swap rate hit a high of 2.406% in early March, when Germany agreed on the biggest overhaul to its fiscal spending in decades, and has since fallen to around 2.12%, having traded above the 2% mark consistently for the last six weeks.
Source: Globalbankingandfinance