European bond yields are expected to decline next year, while the euro may strengthen against the U.S. dollar, despite the upcoming resignation of European Central Bank (ECB) President Christine Lagarde. Lagarde announced her departure effective February 7, 2027, shortly before the ECB held interest rates steady amid ongoing inflation pressures and rising energy costs.
UBS anticipates a smooth leadership transition, with inflation, wages, economic growth, and financing conditions remaining the key drivers of interest rates. The ECB has raised rates twice this year, with inflation running at roughly double its 2% target. While policymakers have hinted at further tightening, UBS believes the central bank will wait for clearer evidence of persistent inflation before acting. A December rate increase remains possible, particularly if higher energy prices fuel broader inflationary pressures.
The bank expects Eurozone sovereign borrowing costs to decline into 2027, despite volatility in French government bonds. France’s fiscal and political challenges could widen sovereign spreads without credible budget consolidation. UBS suggests the ECB could respond to disruptive market pressures through flexible reinvestment of maturing bonds or by using its unused Transmission Protection Instrument.
UBS argues that markets are pricing in excessive tightening, with expectations for another 75 basis points of ECB increases appearing difficult to justify. The bank recommends selectively extending duration in high-quality European bonds, particularly short- and medium-term maturities, including agency, covered, and investment-grade corporate debt. Longer maturities remain less attractive due to fiscal concerns and substantial bond issuance.
For currencies, UBS maintains a bullish euro outlook, forecasting a recovery to 1.16 by year-end. The bank believes the euro’s recent decline has exceeded what underlying economic fundamentals would suggest. However, energy prices, monetary policy differences, sovereign spreads, and geopolitical developments could keep currency markets volatile. UBS also advises progressively reducing excess U.S. dollar exposure where appropriate.