European government bonds sold off in a bear-flattening move on Friday, as higher energy prices coincided with a sharp repricing of French sovereign risk. Germany’s two-year Bund yield rose 5–6bp to 3.28%, while the 10-year added 5bp to 3.52%. In FX, EUR/USD held below 1.15, with energy prices described as relatively little changed.
The ECB’s consumer survey showed slightly firmer inflation expectations in August: the 1Y median rose to 3.0% y/y and the 3Y measure to 2.9% y/y, after trending down since May and then stabilising around 3%. Markets now look to Wednesday’s preliminary September PMIs, with attention on whether euro area momentum, particularly in manufacturing, extends after a strong summer. German politics also moved into focus after Chancellor Merz’s CDU scored 4.9% in Mecklenburg-Vorpommern and 18.8% in Berlin; AfD took 38.2% versus SPD on 35.5% in Mecklenburg-Vorpommern, and Die Linke won Berlin on 25.7%.
Yield Curve Strategies and Inflation Risk
We should prepare for a prolonged period of elevated Eurozone interest rates by positioning for further flattening of the EUR yield curve. With the 2-year Bund yield rising to 3.28% and the 10-year at 3.52%, the yield spread is narrowing as markets price in a tighter monetary policy. We recommend using short-term interest rate (STIR) futures to hedge against the risk of the ECB keeping rates higher for longer.
The halt in the decline of the ECB’s consumer inflation expectations, which have plateaued at 3.0%, suggests that price pressures remain sticky. Historically, when consumer expectations stall near this level, the ECB tends to lean hawkish, similar to the rate patterns of late 2023. We advise buying options on Euribor futures to capture volatility ahead of this week’s preliminary September PMI releases.
FX Positioning and Political Risks
We suggest buying EUR/USD put options or establishing short positions as the currency pair struggles to break above the 1.15 level. Political instability in Germany following the CDU’s poor regional election results, combined with French fiscal worries, is weighing heavily on the euro. This is evident as the French-German 10-year yield spread has widened past 80 basis points, a level of sovereign risk we have not seen since the budget panics of 2024.
As we approach Wednesday’s PMI data, we must closely monitor whether the Eurozone Manufacturing PMI can rise above August’s weak reading of 45.8. A surprise contraction could trigger a sharp reversal in rate expectations, while strong data will likely solidify the bear-flattening trend. We recommend maintaining protective options on energy-linked derivatives to hedge against rising oil and gas prices.
