What’s next for Euro bonds and the euro after Lagarde’s resignation?

European bond yields are anticipated to fall next year, with the euro potentially strengthening against the US dollar, as UBS predicts that Christine Lagarde's early departure from the ECB presidency in February 2027 will not impact the central bank's monetary policy outlook. Lagarde informed the public of her resignation hours before the European Central Bank kept interest rates steady amid ongoing inflation and rising energy costs.

UBS anticipates a seamless leadership change, citing inflation, wages, economic growth, and financing conditions as the key factors influencing interest rates. The ECB has increased rates twice this year, with the inflation rate approximately twice the 2% target. Although policymakers have hinted at the need for further rate hikes, UBS believes the central bank will wait for more conclusive evidence of sustained inflation before taking action.

A possible December rate increase is probable, especially if increased energy prices cause broader inflationary pressures. Nevertheless, UBS expects Eurozone sovereign borrowing costs to decline into 2027, despite ongoing fluctuations in French government bonds. Fiscal and political issues in France might widen sovereign spreads without reliable budget consolidation.

The ECB might respond to market turbulence by reinvesting the maturing bonds flexibly, with its unused Transmission Protection Instrument serving as an alternative option. UBS believes markets are pricing in excessive tightening, with the prospect of another 75 basis points of ECB rate hikes appearing improbable. The bank advocates selectively extending durations in high-quality European bonds, particularly short- and medium-term maturities, including agency, covered, and investment-grade corporate debt.

Longer maturities remain less appealing due to fiscal concerns and substantial bond issuance. UBS maintains its bullish outlook on the euro, projecting EUR/USD to recover towards 1.16 by the end of the year. The bank believes the euro's recent decline has surpassed what underlying economic fundamentals suggest. However, energy prices, monetary policy discrepancies, sovereign spreads, and geopolitical events could keep currency markets volatile. UBS also suggests progressively decreasing excess US dollar exposure where applicable.