We are more constructive on European government bonds

European and US government bonds had rallied strongly from July until mid-September in anticipation of central banks cutting policy rates at a faster pace in the wake of falling inflation and a softening economic backdrop. As short-dated bond yields dropped more than longer-dated ones, the sovereign yield curves finally disinverted. Lower oil prices between July and early September had also contributed to the global fall in sovereign bond yields through lower inflation expectations, but the recent oil price surge on the back of escalating geopolitical tensions in the Middle East reversed this trend in early October. Moreover, market participants have recently revised higher their expected policy rate paths given the resilience of the US and UK economies and the announced Chinese stimulus, which could favourably impact the lacklustre German economy.

After the big US Federal Reserve (Fed) rate cut in September and more dovish comments from the likes of the Swiss National Bank (SNB), the European Central Bank (ECB) and the Bank of England (BoE), we believe that the risk asymmetry is skewed towards lower 10-year European sovereign bond yields. But while all short-term rates have room to fall at least as far as central banks’ terminal rates, the room for further compression of US long-term sovereign bond yields could be more limited given fiscal and political uncertainties.

For this reason, we have moved back to neutral on US Treasuries in favour of long-term euro government bonds, where we are now overweight, along with UK gilts. Given the strength of the Swiss franc we now expect the SNB to become stimulative in the coming months, so we have moved from underweight to neutral on Swiss government bonds. We remain overweight government bonds overall, which could continue to play a protective role in portfolios in this disinflationary environment.