German and Swiss sovereign bonds update

After peaking at 1.76% and 1.46% respectively on 21 June, the German and Swiss 10-year government bond yields have rallied sharply on the back of economic growth concerns to 0.93% and 0.55%, respectively – a fall of more than 80 bp (between 21 June and 27 July).

Through their decisive anti-inflation actions, the European Central Bank (ECB) and the Swiss National Bank (SNB) have set market participants’ expectations for this year’s rises in policy rates, but recession concerns have led to a repricing of their terminal rates lower to 1.04% and 0.57% in 18-month, respectively.

Even if we reckon that increasing downside risks to economic growth in Europe could lead German and Swiss 10-year government bond yields lower in the coming months, the ongoing supply side and gas shortages likely mean inflation will stay high with the ECB and SNB hiking their policy rates further.

In our central scenario, we therefore expect the 10-year German and Swiss government bond yields to rise slightly into year-end to 1.3% and 0.9%, as market participants’ concerns about a severe recession are assuaged.The positive inflation rate differential between the euro area and Switzerland that we project is likely to maintain the yield differential between the 10-year Bund and its Swiss counterpart in positive territory and close to 40 bps.

We stay neutral on core sovereign bonds, expecting them to remain a safe-haven asset in case of recession or financial markets turmoil. Although elevated inflation could put a floor on yields due to further policy rate hikes, long-term yields could experience only a moderate rise into year-end due to lingering growth concerns.

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