Euro area composite PMI data has fallen, pointing to weak growth in the second quarter. At the same time, companies’ input costs are rising and some of these costs are being passed on to customers.
This creates a policy dilemma for the European Central Bank, which faces inflation pressure alongside a soft economy. Commerzbank expects a 25-basis-point ECB rate rise in June.
Policy Dilemma For The ECB
The expected path for rates depends on how the Persian Gulf conflict develops. If the Strait of Hormuz stays closed into the second half of the year, or if hostilities resume, energy prices could stay high or climb further.
Higher energy costs could also push up prices of other goods through indirect effects. In that scenario, the ECB could deliver more than one rate rise, even if conditions for eurozone companies worsen.
The latest flash PMI data for May showed a contraction at 48.9, pointing to a weak second quarter for the Eurozone economy. At the same time, April’s inflation ticked up to 3.1% year-over-year, driven almost entirely by energy costs. This situation puts the European Central Bank in a very difficult position ahead of its June meeting.
We see the market pricing in a 25 basis point hike in June as a near certainty, which seems to be the path of least resistance. This suggests positioning in short-term interest rate futures, like those on €STR, to reflect this minimal expected move. However, the real play is not on the base case but on the significant upside risk to this forecast.
Market Strategies And Risk Scenarios
The primary risk comes from the Persian Gulf, where Brent crude has been holding above $110 a barrel for the last month. Shipping insurance premiums for tankers passing through the Strait of Hormuz have also surged by over 50% since April. These are hard costs that will continue to feed directly into inflation numbers for the coming months.
This high level of uncertainty makes buying options on interest rate swaps, known as swaptions, an attractive strategy. These instruments provide a way to profit if the ECB is forced into a more aggressive hiking cycle of multiple raises than is currently expected. The cost of these options is still reasonable given the potential for a hawkish surprise if energy prices do not retreat.
The euro’s direction is also unclear, creating opportunities in FX options. While rate hikes are typically bullish for a currency, a slowing economy could cap any significant EUR/USD upside. This suggests trades that profit from range-bound movement or increased volatility, rather than a strong directional bet.
Looking back at the policy pause in late 2025, we know the central bank is hesitant to tighten into an economic slowdown. That past reluctance is what makes the current energy price shock so challenging for policymakers. This is why forward-looking volatility metrics, like the VSTOXX, have been creeping higher and are worth watching.
