Investors' attention turns to the European Central Bank's meeting on Thursday, amid broad consensus to keep interest rates unchanged. However, the focus will be on the messages sent by President Christine Lagarde regarding the future path of monetary policy, amid the escalating war between the United States and Iran and the return of oil prices to rising.

Although markets price in a probability of less than 5% for a rate hike at the current meeting, the continued rise in energy prices and fears of renewed inflationary pressures are prompting investors to anticipate a more hawkish tone from the bank, which could pave the way for a new rate increase in September.

Analysts at ING believe that the meeting, which was expected to be quiet, has become one of the most important meetings this year after geopolitical developments in the Middle East reshaped market expectations regarding monetary policy.

Oil returns to lead the scene

Analysts point out that oil prices have regained their role as the main driver of interest rate expectations, just as happened at the start of the war between the US and Iran, as the rise in crude quickly reflected in increased investor bets on monetary policy tightening.

Markets currently price in a rate hike at the September meeting almost fully, while expectations beyond that remain less clear, giving the ECB an opportunity to influence investor expectations through the tone of its statement and press conference.

Nevertheless, ING analysts believe that even if the ECB resorts to a surprise rate hike of 25 basis points this week, it will likely not lead to a significant rise in bond yields, as markets may interpret the move as bringing forward a hike expected in September, rather than the start of a new tightening cycle.

The central bank's meeting to discuss the interest rate decision chaired by Lagarde last June (the bank)

Division within the Governing Council

According to the report, the absence of updated economic forecasts during the July meeting makes the statement and press conference more important than usual. Analysts expect the continued influence of more hawkish members within the Governing Council, seeking to maintain market expectations of one or two additional rate hikes before the end of the year and prevent inflation expectations from becoming unanchored due to the continued rise in energy prices.

Although the bank may not explicitly state that September is the likely timing for the next hike, markets could infer this message from officials' statements or from the usual leaks after the meeting.

Real interest rates at their highest levels

The report notes that one of the most notable differences compared to previous months is the rise in real interest rates in the euro area, driven by a relative improvement in growth expectations and increased market conviction that central banks will keep interest rates higher for longer.

The more hawkish stance of US Federal Reserve Chairman Kevin Warsh than markets had expected also contributed to reinforcing these expectations globally, leading to a rise in bond yields even as oil prices remained below $100 per barrel.

What does that mean for the euro?

In the currency market, the report sees that the continued resilience of the euro requires the ECB to adopt a hawkish tone, but that alone may not be enough. The euro has benefited in recent weeks from the narrowing gap between interest rate expectations in Europe and the US, but the continuation of the war in the Middle East and rising energy prices could increase pressure on the European currency through its impact on economic growth and increased investor appetite for safe-haven assets.

ING analysts expect the euro to remain above $1.14 if the bank maintains hawkish messages, but they do not rule out a return to test its lowest levels recorded in June if geopolitical fears overshadow monetary policy decisions.