The Eurozone money markets on Monday point to a sharp strengthening of expectations that the ECB will raise rates by 75 basis points in September, as the ECB officials signaled over the weekend that they were ready to take a drastic step to quell inflation.

Among the ECB representatives who spoke at the Jackson Hole symposium, Isabel Schnabel gave an important signal. She said that there is a growing risk that public inflation expectations will de-anchor (which would dramatically reduce the effectiveness of the ECB monetary policy), while surveys show that high inflation is beginning to undermine the credibility of the central bank policy.

Other officials noted that front-loaded rate hikes (rather than based on incoming economic data) are justified, and that the neutral interest rate (at which the tightening cycle should end) may be somewhere near 1.5% and should be reached by the end of this year or by the end of the first quarter of 2023.

Traders in the EU money markets factor in a policy tightening of around 67 basis points in September. This means that there is no doubt that the ECB will raise rates by at least 50 basis points in September, and the chances of a 75 bp increase are estimated at 67%. On Friday, the chances of this outcome were only 24%.

Along with the strengthening of expectations that the ECB rate will increase rapidly, the yield of the EU’s key sovereign bonds – the German Bunds – also increased markedly. On Monday, two-year German bonds offered a yield of 1.16%, up 19 basis points from Friday, the highest since June 17. The far end of the yield curve also climbed, with 10-year bonds offering a yield of 1.54%, the highest level in two months:

Market rumors that the ECB will act decisively should offer solid support to the European currency until September, so a EURUSD move towards 0.95 will most likely hit roadblocks. The divergence in the expected pace of policy tightening is clear from the returns of the EURUSD and GBPUSD in recent days: while the pound has dipped more than 1% against the dollar since the middle of last week, recovering somewhat later, the European currency has gained 0.6% over the same period:

The likely tightening of the ECB’s policy has also created additional strains in the EU sovereign debt market. A key indicator of credit risk in the bond market, the spread between Italian and German bonds widened to 2.36%, the highest in a month. In the event of an excessive increase in the spread, the ECB will have to use the monetary policy Transmission Protection Mechanism (TPI), which consists in buying bonds of those countries of the block where yields grow excessively due to the irrational reaction of investors. This measure will reduce the cost of borrowing for the countries of the bloc’s periphery such as Italy, Greece, Spain, etc.