European bond yields are expected to decline next year, while the euro may strengthen against the U.S. dollar, according to UBS. This outlook comes despite the upcoming resignation of European Central Bank (ECB) President Christine Lagarde, which is set to take effect on February 7, 2027. UBS believes the leadership transition will not significantly alter the ECB’s monetary policy, as inflation, wages, economic growth, and financing conditions will remain the primary drivers of interest rates.
The ECB has already raised rates twice this year, with inflation running at roughly double its 2% target. While policymakers have hinted at further tightening, UBS suggests the central bank will wait for clearer evidence of persistent inflation before acting. A December rate increase remains possible, especially if higher energy prices fuel broader inflationary pressures.
UBS anticipates Eurozone sovereign borrowing costs will drop into 2027, despite ongoing volatility in French government bonds. France’s fiscal and political challenges could widen sovereign spreads without credible budget consolidation. The ECB may respond to disruptive market pressures through flexible reinvestment of maturing bonds or by using its unused Transmission Protection Instrument.
The bank argues that markets are overestimating the likelihood of further ECB rate hikes, with expectations for another 75 basis points of increases appearing unjustified. UBS 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 are seen as less attractive due to fiscal concerns and substantial bond issuance.
For currencies, UBS maintains a bullish outlook on the euro, forecasting a recovery to 1.16 by year-end. The bank believes the euro’s recent decline has been more severe than 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.