European stocks see biggest drop in two months! Oil prices break $100, triggering inflation warning; markets bet on four rate hikes by ECB and Bank of England

Brent crude surpassed $100 per barrel for the first time since July, causing a sharp slump in European equities and a surge in inflation expectations, prompting traders to ramp up bets on substantial rate hikes from the European Central Bank and the Bank of England.

The STOXX Europe 600 Index closed down 1.41% on Wednesday at 640.4 points, marking its largest single-day drop since July. The blue-chip Eurozone STOXX 50 Index fell in tandem by 1.58%, closing at 6311.56 points.

The escalation of US-Iran tensions pushed oil prices higher, intensifying concerns about persistent inflation and worsening the volatile pattern in European equities following their record highs in August.

The reaction in the rates market was even more dramatic. Swap pricing shows that traders now expect the European Central Bank and the Bank of England to each raise rates by about 90 basis points by the end of 2027. This implies three hikes of 25 basis points by both central banks, with roughly a 60% chance of a fourth.

The yield on two-year German bunds—seen as highly sensitive to monetary policy expectations—rose to 3.08% on Wednesday, its highest since June 2024.

The renewed escalation between the US and Iran pushed Brent crude above $100 per barrel for the first time since July, acting as the direct trigger for the current bout of market turbulence.

Natixis CIB strategist Emilie Tetard noted, "$100 per barrel seems to be the key threshold that triggers a shift in the market narrative."

Europe and the UK are highly dependent on imported oil and gas, making both economies especially sensitive to surges in energy prices.

Lauren van Biljon, Senior Portfolio Manager at Allspring Global Investments, pointed out, "With oil back above $100 per barrel, the UK and Europe remain highly correlated with energy prices." She added that the pass-through effect of energy prices to inflation, combined with the eurozone’s greater-than-expected economic resilience, has contributed to the market's "aggressive" pricing for ECB rate hikes.

The European Central Bank is expected to announce a rate hike at its policy meeting on Thursday, and Governing Council member Joachim Nagel has already given a clear signal for an imminent rate increase.

This downturn impacted nearly all sectors in European equities, with cyclical sectors such as construction & materials and retail suffering the most.

The STOXX 600 Construction & Materials Index fell 2.57%, the Retail Index dropped 2.56%, Personal & Household Goods declined 2.39%, Industrial Goods & Services declined 2.34%, and the Food & Beverages Index fell 2.12%.

The retail sector’s pressure partly stemmed from individual stock drags—fast fashion giant Inditex SA slipped 3.6% after its first-half earnings missed analyst expectations.

Among blue chips, France's Saint-Gobain lost 3.9%, Adyen dropped 3.84%, and Germany’s Rheinmetall was down 3.75%. The worst-performing stocks in the STOXX 600 included Auto1 Group (down 6.47%), Rightmove (down 5.02%), and Kering Group (down 4.97%).

The oil and gas sector bucked the trend, closing up 0.26%; Italian energy giant Eni rose 1.91% and TotalEnergies gained 0.59%, among the few blue-chip components posting gains.

Despite the sharp rise in rate hike expectations, some analysts warn that current swap pricing may exceed central banks’ actual policy intentions.

Bank of England Governor Andrew Bailey has recently played down the likelihood of imminent rate hikes. CG Asset Management portfolio manager Emma Moriarty believes that it is "unlikely" that as many as four rate hikes will be required to tame inflation pressures, given the UK’s lackluster economy.

van Biljon agreed that the latest round of Bank of England hike bets "does not look reasonable."

Market strategist Evelyne Gomez-Liechti commented that market expectations for rate hikes from both the European Central Bank and Bank of England "appear overly optimistic."

Strategists at Bank of America also advised clients to go long on short-dated eurozone bonds, arguing that ECB rate hikes have been over-priced, due to the lack of evidence for widespread inflationary pressures and the downside risks facing the eurozone economy, which will likely limit the central bank's room for further hikes.