As international energy prices continue to climb, stoking concerns that inflation will remain elevated over the next year, traders are significantly ramping up wagers on additional interest rate increases from the European Central Bank (ECB) and the Bank of England (BoE). Interest rate swap markets currently price in roughly 90 basis points of cumulative tightening from both central banks by the end of 2027. However, some investors and Wall Street institutions believe that the market may have already priced in too many future rate hikes.

The latest interest rate swap pricing indicates that the market now expects the European Central Bank to deliver approximately 90 basis points of cumulative rate increases by December 2027, the highest level since the start of this monetary tightening cycle. This suggests that the ECB is expected to implement at least three quarter-point hikes during this period, while the market also factors in around a 60% probability of a fourth increase. Expectations for the Bank of England have also risen noticeably. Swap markets now project similar cumulative hikes of close to 90 basis points for the BoE, and if this forecast materializes, the UK benchmark rate would reach its highest level since February 2025.

The core driver behind this rapid shift toward a hawkish stance is the surge in energy prices. Europe and the UK rely heavily on imported oil and, particularly, imported natural gas, making their economies more sensitive to spikes in international energy costs compared to energy-producing nations like the United States. With the war involving Iran heightening energy supply risks, international crude prices have broken back above the $100-per-barrel threshold. Investors now worry that a fresh energy shock could push inflation higher through channels such as transportation, electricity, production costs, and consumer prices. Lauren van Biljon, senior portfolio manager at Allspring Global Investments, noted that oil has re-crossed the $100 mark, and both the UK and European economies and their inflation rates remain highly correlated with energy prices.

Beyond the energy price shock, the eurozone economy's stronger-than-expected performance is another key reason behind the market's sharply increased bets on ECB rate hikes. If the economy can withstand higher borrowing costs, the European Central Bank gains more room to pursue its inflation-control policies. The market widely anticipates that the ECB will raise rates at Thursday's monetary policy meeting. ECB Governing Council member Joachim Nagel has already signaled a rate increase this week, though he remains cautious about the policy path beyond that. The sharp rise in rate-hike expectations has also quickly transmitted to European bond markets. On Wednesday, short-dated European government bond yields broadly advanced, with Germany's 2-year yield, the most sensitive to monetary policy shifts, briefly climbing to 3.08%, its highest level since June 2024.

However, as markets begin positioning for multiple potential rate hikes from both the ECB and the BoE, some investors argue that current pricing has become overly aggressive. While European Central Bank officials have shown a relatively high degree of openness to further near-term policy tightening, they remain cautious about consecutive increases. Nagel, despite hinting at a possible hike this week, has made no clear commitment to sustained tightening thereafter. On the other side, Bank of England Governor Andrew Bailey has also sought to downplay the likelihood of another near-term rate rise. Emma Moriarty, portfolio manager at CG Asset Management, believes that given the UK economy's continued weakness, the prospect of inflation shocks severe enough to require as many as four rate hikes from the BoE is unlikely. Van Biljon echoes this view, suggesting that the recent rapid escalation in BoE rate-hike expectations "does not seem reasonable." Market strategist Evelyne Gomez-Liechti added that investors may currently be "wrongly inclined to price in excessive rate hikes" from both the ECB and the BoE.

Strategists at Bank of America also advise investors to remain cautious regarding the hawkish expectations currently embedded in eurozone short-end rate markets. The bank argues that there is still insufficient evidence to prove that rising energy prices have evolved into broader, more persistent inflationary pressures. Additionally, the increasing economic headwinds gathering in the eurozone will constrain how much further the European Central Bank can actually raise rates.