Key Takeaways
- After a volatile first half of the year, eurozone bond markets will continue to be driven by uncertainties related to the war in the Middle East, the ECB’s monetary policy, and individual countries’ public finance decisions.
- The supply of government bonds is set to increase, particularly in Germany and France, while it is expected to decline in Italy and Spain.
- According to some fund managers, conditions could become more favorable for bond markets in the third quarter compared with the first half of the year, especially if inflation settles at levels lower than those currently priced in by the markets.
Eurozone bond markets are bracing for two inflationary scenarios in the third quarter amid significant geopolitical and economic uncertainty. The first scenario sees an end to the conflict in the Middle East, leading to a drop in energy prices and a cooling in inflation. The second assumes the war will continue, leading to a new wave of price increases—not only for oil and natural gas, but also for fertilizers and other commodities- that could trigger a further increase in interest rates this year. Each scenario has significant implications for the direction of bond yields and prices.
For the government bond market—which has been volatile in the first part of the year and has yet to return to January 2026 levels—more months of ups and downs are on the horizon. Since the start of the year, the Morningstar Eurozone Treasury Bond Index has declined by 0.6%.
Geopolitical Risk Remains a Key Factor for Government Bonds
In the third quarter, geopolitical risk remains a key factor, according to portfolio managers, as negotiations between the US and Iran appear set to drag on for some time, and a final agreement seems out of reach.
“Uncertainty will remain high, especially regarding oil prices and their impact on global inflation,” says Mauro Valle, head of fixed income at Generali Asset Management. This will complicate the task of the European Central Bank, which, after an initial interest rate hike in June, will have to decide whether to continue tightening monetary policy without risking an economic slowdown.
In its June macroeconomic projections, the ECB said that the conflict in the Middle East “is weighing on the short-term growth outlook, with energy price shocks and uncertainty proving stronger and more persistent than previously expected, further reducing purchasing power and confidence.” The ECB lowered its GDP forecasts from 0.9% to 0.8% for 2026 and from 1.3% to 1.2% for 2027. It also revised its inflation forecasts upward from 2.6% to 3.0% for this year and from 2.0% to 2.3% for next year.
However, Flavio Carpenzano, Capital Group’s asset class lead for fixed income in Europe and Asia, expects growth to remain “relatively resilient” in the third quarter, while he sees greater risks of negative surprises from inflation. “The prevailing environment is best described as a phase of moderate but still positive growth, accompanied by widespread but manageable inflation.”
Energy Crisis and Defense Spending Weigh on Public Finances
Geopolitical shocks have worsened the state of public finances, with 10 European Union countries—according to Goldman Sachs—set to be subject to excessive deficit procedures this year. The reasons range from the energy crisis to increased defense spending, from structural economic weakness to inflationary pressures.
“The latest fiscal trend points to wider deficits across the bloc, with the aggregate euro area deficit projected at 3.3% of GDP in 2026,” Goldman Sachs wrote in a note on June 19. By contrast, the analysts say that in the 2012-2019 period “EU countries undertook significant fiscal consolidation following the sovereign debt crisis, bringing the aggregate euro area fiscal deficit to 0.5% of GDP in 2018.”
To finance themselves, governments may be forced to increase government bond issuance, leading to a rise in the supply of debt. However, Andrea Campisi, senior investment manager at Pictet Asset Management, says investors should focus on net supply—which accounts for maturing bonds—as this is the key factor for the markets.
“Net supply in 2026 for the euro area will be just 10 billion higher than in 2025—a figure easily manageable by investors—but with significant divergences among countries. Core issuers such as Germany and France will see their net supply increase significantly compared with 2025, while countries like Italy and Spain will see it decrease,” Campisi says.
According to Sylvain De Bus, deputy head of Global Bonds at Candriam, the main factors to monitor in the eurozone government bond markets over the coming months will be the evolution of the conflict in the Middle East, the European Central Bank’s monetary policy path, and fiscal and political developments at the national level, particularly in France and Italy.
Will the ECB Raise Interest Rates Again in 2026?
Markets are pricing in further interest rate hikes by the ECB in 2026, but they are also weighing the possible effects of a further rise in inflation on economic growth. While the possibility of stagflation—a mix of economic stagnation and high prices—cannot be ruled out, it is believed that a slowdown in growth could mitigate inflation. According to Pictet’s Campisi, “current market expectations for one and a half rate hikes this year are excessive.” The expectation is for a single additional hike should the energy and wage shocks surprise on the upside.
According to Capital Group’s Carpenzano, the ECB will maintain a “cautiously hawkish stance through Q3, following its 25 basis points rate hike in June, and is likely to deliver a further increase in September.”
Mark Dowding, fixed income CIO at RBC BlueBay AM, thinks the ECB will keep rates unchanged at its upcoming meetings. “Against the backdrop of weaker economic growth, we should see inflation moderate more quickly than in the United States,” he says in a June 19 note.
However, the central bank does not look solely at consumer price data but also at inflation expectations. The possibility that the supply shock caused by the war in the Middle East could spread to fertilizers, liquefied natural gas, aluminum, and other commodities—not to mention the impact of artificial intelligence developments on inflation—risks fueling expectations of ever-higher prices among consumers.
“For central banks, the risk that inflation expectations will lose their anchor is complicating the monetary policy outlook and fueling a new wave of volatility in bond markets,” says François Rimeu, senior strategist at Crédit Mutuel AM, in a note on June 18. “In the eurozone, the trend has been even more pronounced [compared with the United States], with 30-day volatility on the nine-year French government bond rising from about 3% to over 8%.»
Government Bonds: Where to Invest in the Third Quarter?
According to some fund managers, conditions could become more favorable for bond markets in the third quarter compared with the first half of the year, especially if inflation settles at levels lower than those currently priced in by the markets. A reduction in inflation pressures could lead to a decline in government bond yields and, consequently, a rise in prices. The two variables move in opposite directions.
“We expect sentiment in the bond market to improve,” says Daniel Kittler, senior fixed-income portfolio manager at DWS. He leans toward medium to longer maturities bonds.
Pictet Asset Management’s portfolios “reflect positive expectations for euro-denominated government debt in the third quarter, with a preference for intermediate maturities as they are more defensive against potential rises in short-term yields in the event of surprises related to second-round effects on consumer prices,” Campisi says.
Candriam’s De Bus says he is focusing on 10-year bonds, but that he will be selective regarding spreads—the differentials between peripheral bonds, such as Italian ones, and the German bund. If geopolitical tensions ease, leading to a decline in energy prices, “we believe that euro-denominated duration looks attractive at yields above 2.9%. »The duration is a measure of a bond’s price sensitivity to interest rate changes. De Bus also maintains a selective exposure to certain Central and Eastern European countries, such as Slovenia and Slovakia, which could benefit from their inclusion in some euro-denominated bond indexes in 2026.
Capital Group’s Carpenzano maintains a more cautious approach to EUR duration, “with a preference for shorter-dated yields and noncore European rates.” He remains overweight sovereign spreads in countries such as Greece and Italy, as spreads are expected to continue tightening both in the near term and long term, supported by improved fundamentals and Germany’s fiscal shift. But he is underweight on France sovereign debt.
Finally, with inflation increasingly becoming a structural risk, Rimeu of Crédit Mutuel AM considers floating-rate notes “the most suitable solution because their coupons are reset periodically, allowing them to adapt to changes in monetary policy and higher interest rates. Furthermore, their sensitivity to rate movements remains very limited, which translates into minimal duration risk.”
