The drums of war in the Middle East often trigger a particular kind of financial market volatility and overreaction. Since late February, following the escalation involving Iran, European rates markets have shifted sharply. The European Central Bank was widely expected to remain on hold for much of the year, but recent market moves have given way to whispers of hikes. Inflation, it is feared, is about to make a comeback.
At first glance, the reaction is understandable. Europe remains sensitive to energy shocks, and memories of the inflation surge following the Russia-Ukraine war are still afresh. But a closer look at the current macro backdrop suggests that markets are over-extrapolating past dynamics onto a very different present. The repricing underway appears driven more by narrative than by fundamentals.
At the onset of the Ukraine war in 2022, Europe was structurally exposed. It relied heavily on Russian gas, had limited LNG infrastructure, and entered the crisis with insufficient storage. The result was a genuine supply shock with TTF natural gas prices hitting €340 per MWh in August 2022. Today, the starting point is fundamentally different. Since then, Europe has built resilience into its energy system. LNG import capacity has expanded, supply sources have diversified, and storage levels remain relatively robust. In fact, during this year’s supply shock scare, LNG prices reached €62 per MWh. A far cry from the situation in 2022.
The day before the start of the Iran war, market participants were anticipating a 50% chance of a single rate cut by year-end. At the time of writing, these expectations have shifted dramatically with markets now anticipating three hikes by the end of 2026. However, we believe that these expectations are overblown as we will explain why in the points below.
Inflation Expectations Remain Anchored
The German 5yr5yr forward breakeven rate, which is a market-based measure of long-term inflation expectations, increased only slightly from the start of the war and appear to remain anchored at around 2%, which is a much smaller move than the sharp increases seen during the post-COVID reopening and the start of the Ukraine war. This also shows that the market thinks that this new bout in inflation is transitory. There is one genuine area of stickiness: services inflation. It remains elevated across much of the eurozone, reflecting the lagged nature of services price-setting, such as indexed contracts, and the time it takes for wage disinflation to feed through into prices. This is real, but it is a rearview mirror phenomenon. Services inflation reflects where the economy was, not where it is going. The leading indicators of services price pressure such as wages and hiring intentions are both softening.
Labour market Pressures Are Easing
The inflation scare of 2021-2023 was fundamentally a story of an economy which was operating above its potential due a combination of too much demand, too little supply and a labour market that was running hot. That story seems to have run its course in Europe. The labour market is an important mechanism in the inflation framework. Strong wage growth can push inflation higher, but this pressure looks to be easing. Wage growth across the eurozone is moderating and is now only slightly above inflation. More importantly, eurozone vacancy rates have been falling, leaving less room for employees to negotiate their wages.
A Negative Output Gap is Disinflationary
Perhaps the most underappreciated argument against an inflation resurgence is simply that the European economy is operating below its potential. Potential GDP is the maximum sustainable output an economy can produce when using all resources at full capacity, before it starts to increase the inflation rate. Economic growth or demand in Europe remains weak, and continuous soft data continues to reinforce this thinking. An economy with spare capacity and weak demand is structurally disinflationary. The output gap, a measure of the difference between the actual output of an economy and its potential output is negative, suggesting that the economy has room to absorb shocks without translating them into immediate broad price pressure.
China is Exporting Disinflation
Another factor that receives insufficient attention in European inflation discussions is the disinflationary impulse flowing from China. Chinese producer prices, which measure the prices factories charge for their goods, have been in disinflation for an extended period, reflecting structural overcapacity across key sectors. Weak domestic demand has led Chinese firms to push exports aggressively into global markets. Around 20% of all EU imports originate from China. These pricing pressures in China do not stay domestic. They pass through to European import prices, helping to keep goods inflation low. A strengthening euro amplifies this channel. Most imports from China to Europe are priced in US dollars, so a stronger euro makes them cheaper. Currency appreciation mechanically reduces the euro cost of imported goods and energy, providing an additional disinflationary buffer that was absent during the 2022 crisis.
Implications for ECB Policy
All this raises the question of how the ECB might react at the next meetings. The ECB has historically focused on medium-term inflation, not short-term volatility. Energy-driven price movements are typically “looked through” unless they generate second-round effects, where higher energy prices, push wages up and embed inflation more broadly. At present, those second-round effects are not evident. Inflation expectations remain anchored, wage growth is moderating, and demand conditions are weak. Tightening policy into this backdrop would risk amplifying downside growth risks without materially improving inflation outcomes. A more plausible path is one of cautious patience, monitoring incoming data while filtering out all the noise and overreaction related to geopolitical developments. In short, markets are reacting to geopolitical headlines, but the underlying data does not support a sustained resurgence in inflation.
Written by
Ishmael Mizzi
Assistant Portfolio Manager – ReAPS Asset Management
The information contained in this article represents the opinion of the contributor and is solely provided for information purposes. It is not to be interpreted as investment advice, or to be used or considered as an offer, or a solicitation to sell/buy or subscribe for any financial instruments nor to constitute any advice or recommendation with respect to such financial instruments. This article was issued by ReAPS Asset Management Limited, a subsidiary of APS Bank plc. ReAPS Asset Management Limited (C77747) with registered address at APS Centre, Tower Street, Birkirkara BKR 4012 is regulated by the Malta Financial Services Authority as a UCITS Management Company and to carry out Investment Services activities under the Investment Services Act 1994 and is registered as an Investment Manager under the Retirement Pensions Act.
