Traders Bet on ECB Hike Amid Inflation Upheaval

In a matter of days, the financial market has undergone a significant shift in its outlook regarding the European Central Bank's forthcoming decision, underscoring the pervasive uncertainty surrounding this critical event.

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Presently, money markets are assigning a 68% probability to the likelihood that the ECB will implement a quarter-point increase in interest rates. This shift in perspective has occurred rapidly in recent weeks, largely in response to mounting evidence of persistent inflationary pressures in Europe, compounded by the surge in energy prices.

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At the outset of September, market sentiment firmly leaned towards the ECB maintaining interest rates to safeguard economic growth, with merely a 20% chance of a rate hike factored into market expectations.

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However, the landscape has evolved in light of reports suggesting that the ECB anticipates inflation to remain above the 3% threshold into the following year. Analysts contend that, given these circumstances and the increasing vulnerability of the euro, the central bank will find it increasingly challenging to refrain from taking action. Dutch Governor Klaas Knot emphasized last week in an interview with Bloomberg that investors might be "underestimating" the likelihood of a forthcoming increase in borrowing costs.

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Alberto Gallo, Chief Investment Officer at Andromeda Capital Management Ltd., described the ECB's situation as a "lose-lose" scenario, driven by the stubborn nature of inflation. In a recent interview with Bloomberg Television, Gallo stated, "Markets are justified in pricing in another rate hike from the ECB," but cautioned that this move might ultimately be viewed as a policy mistake.

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Even within the ECB itself, the decision appears to be hanging in the balance. Reports suggest that the decision is so finely balanced that officials attending the upcoming gathering, which begins on Wednesday, are also awaiting the outcome with a sense of suspense.

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This evolving sentiment has had repercussions in the bond market, particularly at the shorter end of the yield curve. The German two-year yield, known for its sensitivity to monetary policy adjustments, rose by four basis points to reach 3.17%, marking its highest level since mid-August. Italian government bonds also experienced a decline, leading to a five basis point increase in the 10-year yield, which now stands at 4.45%.

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