Outrageous Predictions
Executive Summary: Outrageous Predictions 2026
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Stagflation builds the case for short-term real and nominal sovereigns
Althea Spinozzi
Head of Fixed Income Strategy
Summary: European and UK PMIs and stubborn inflation expectations paint the perfect stagflation picture for the old continent. While the BOE might need to tighten further, the ECB is unlikely to hike rates again. As the hiking cycle ends, short-end government bonds provide enticing returns. However, short-term inflation linkers remain in the spotlight as inflationary pressures might resurface in the last quarter of the year.
Germany and the Netherlands are in a recession, and PMI numbers paint an ugly picture for Europe. Yet, inflation expectations have slowly risen, showing that the ECB 2% target might not be plausible.
Within this context, the ECB will have its hands tied as it won't be able to cut or hike rates, not to spur inflationary pressures, nor to drive the euro economy into a recession.
That means that front-term yields will be anchored for some time, while long-term yields might adjust lower as a recessionary picture develops.
Although things might be different for the BOE as another rate hike might be necessary, it is impossible not to acknowledge the attractiveness of short-term government bonds within this context.
As uncertainty remains elevated, we favor short-term European government bonds, especially inflation linkers, as inflationary pressures might resurface during the last quarter of the year.
The 2-year German swap remains elevated.
It indicates that market expectations are still anchored around a higher for longer rate scenario, providing little room for government bonds to rally. That explains the bull flattening of the European yield curve after the ugly PMI reading, with 2-year Schatz yields remaining around 3%. Indeed, while bond future markets have pushed back on bets of another ECB interest rate hike, they are still pricing a 10bps hike by September and 15bps by October.
Europe’s inflation expectations have increased since last month
The problem the ECB is facing is that amid an economy in contraction, inflation expectations have increased within the last month. That builds a floor for front-term yields, while long-term yields are able to fall amid recessionary fears.
Short-term European sovereign bonds
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