HSBC suggests that market expectations for European Central Bank interest rate hikes are excessive, leading to elevated yields on German short-dated government bonds and making the 2-year German bond appear cheap relative to its fair value.

HSBC European rates strategist Chris Attfield wrote that, in most scenarios, the short end of the yield curve appears significantly undervalued, currently pricing in two to three rate hikes. He stated that even if the ECB raises rates once in September and then holds steady until the end of next year, the yield on the German 2-year bond would still be about 20 basis points above its fair value.

Money markets currently indicate expectations for 62 basis points of ECB rate hikes by the end of next year. In contrast, HSBC's forecast is for no further hikes, with one rate cut projected for the fourth quarter of 2027.

Attfield noted that the elevated market yields exist because markets are not adept at "anticipating turning points," with investors reluctant to price in the end of a hiking cycle and the potential for lower rates.

HSBC has revised down its forecast for the German 2-year bond yield at the end of this year from 2.85% to 2.5%. Its projection for the end of 2027 stands at 2.2%.

HSBC strategists also maintain a moderately positive view on UK government bonds, stating that the "short end of the curve offers the most value."

Money markets currently price in 68 basis points of Bank of England rate hikes by the end of next year. UK consumer price index (CPI) inflation rose 2.6% year-on-year in June, coming in below expectations.