The ECB's wartime hikes are likely to be reversed

On September 10th the European Central Bank raised its deposit rate by a quarter point, to 2.50%, its second such increase in three months. The move is the institution's answer to an energy shock it did not cause and cannot cure. Since the summer, the war between the United States and Iran has threatened the shipping lane that carries much of the world's oil; Brent crude touched $100 a barrel in early September after peaking near $120 in April. Euro-zone inflation, which had fallen toward target, re-accelerated to 3.3% in August, driven by energy prices up 14.3%. The ECB chose to lean against all of it.

A shock that rates cannot fix

The decision forced the Council to choose between two bad options, because an energy-price spike is an unusual kind of inflation. Rates cannot conjure a barrel of oil. A higher interest rate suppresses demand, which does nothing to restore supply; it mostly lowers the amount of spending that the same, dearer energy can support. That is the core of the case against tightening, and it is the position UBS has taken. The Iran conflict is "a classic energy supply shock," the bank argued in the spring, one that monetary policy is ill-equipped to address; raising rates to stop supply-driven inflation, on this view, is reaching for a demand-side tool to treat a problem on the other side of the ledger. UBS called the market's expectations of a wave of hikes "too hawkish" and advised the ECB to "look through" the shock. This is the stance that the report titled "We Expect ECB to Reverse" condenses: the tightening episode, on this reading, is a detour, not a destination.

The background makes the detour comprehensible. The ECB had hiked ten times between 2022 and 2023, lifting the deposit rate from minus 0.50% to a record 4.00%, then cut it eight times from September 2023 back to 2.00%. That truce lasted until the war. In June the Council resumed tightening — the first hike since 2023 and the first by any major central bank in response to the conflict — and in September it went again. Whatever the next move, this is now a cycle, and the only question is where it stops.

Why the market wants more, and UBS expects less

Here the market and the institution that set its rate path are in open disagreement, and that disagreement is the whole risk. Traders have priced a "fully-fledged tightening cycle": futures implied a rising probability that the deposit rate reaches 3% by late 2027, and the market's read of the zone's neutral rate climbed to roughly 2.85%. The worry behind the pricing is that the shock stops being merely energetic — that dearer diesel, petrol and food feed into wages and broader prices, the "second-round effects" that made the 1970s and the post-2022 inflation so persistent.

The economists who study the zone professionally are far less convinced. A Reuters poll of 65 economists expected the September hike to be the second and final one: 91% saw the deposit rate still at 2.50% at year-end, and 78% thought it would remain there through mid-2027. Their doubts rest on a handful of shared observations. Second-round effects are so far tentative; core inflation actually eased, to 2.4% in August. Bastian Freitag of Rothschild & Co argued that base effects in oil prices should make headline inflation look kinder from March 2027, and that the ECB's own mechanics cut against a long campaign: a rate rise takes nine to eighteen months to bite, so the full weight of June's hike lands in early 2027, precisely when the zone's economy — forecast to grow a meagre 0.8% this year — would least welcome it. Fighting, on the one hand, a textbook supply shock with, on the other, a tool that arrives late and hits demand.

The intuition against more hikes is consequently strong. Yet the ECB hiked anyway, and that reveals what the market is really pricing: not that energy prices will stay high, but that the cost of doing nothing is higher. If inflation runs hot while the Council merely shrugs, expectations can drift, sovereign-bond markets — already demanding multi-decade-high yields from European governments — would punish the target, and the credibility that took a decade to rebuild would leak away. Two hikes are, in effect, an insurance premium paid to prove the 2% promise is not negotiable. The premium may be unduly dear, but it is not irrational.

What a reversal would mean across the Atlantic

For a United States investor the direction of this argument matters more than its Eurocentric details, because it moves the prices in an American portfolio. European bond yields at multi-decade highs pull on global discount rates and on Treasuries; a policy that tightens further is a drag on global growth and on the earnings of U.S. multinationals with European exposure. The dollar is in the mechanism too. UBS, as part of the same judgment, expected the euro to firm toward $1.20 and the dollar to weaken as the United States' interest-rate advantage narrows — a forecast the war, by pushing the ECB the other way, complicates but does not refute.

The genuinely useful finding for the reader is the split itself. Traders and economists do not often disagree so openly about where a short cycle tops out, and the gap is a live piece of market information rather than a curiosity. If the conflict drags on and wages follow energy, the hawkish pricing is vindicated and European rates keep climbing — a headwind for growth assets on both sides of the ocean. If, as UBS and most economists expect, the shock rolls over, inflation retreats, and second-round effects stay absent, then the repricing toward 3% unwinds, European yields fall, and the rate-sensitive and growth parts of the market get a reprieve. The reversal UBS predicts is not an exotic call. It is the ordinary arithmetic of a supply shock meeting an economy too fragile to absorb the medicine.

None of this tells the reader whether to buy or sell a European bond or a euro. It describes the bet underneath the headlines: that the ECB has paid for credibility with two hikes and will not be asked to pay much more. Two variables would falsify that bet — the war's duration, and whether its cost shows up in wages. Watch those before watching the next meeting.