To watch German bonds this year has been like witnessing a horror show. Yet, we are only nearing intermission -- meaning there is far worse to emerge in the months ahead.

However, in the post-pandemic world that has completely upended the region's inflation outlook, a nominal neutral rate would perforce be higher than its 2% target assuming that the ECB targets a neutral real rate of at least zero. In fact, given that HICP is currently running at almost 9%, it may be argued that the short-term neutral nominal rate is somewhere between 2.50% and 3%.

In other words, it is possible that the ECB may raise rates all the way to around 3% should inflation prove to be stubbornly high in the coming quarters, with President Christine Lagarde having commented in May that "a progressive further normalization of interest rates toward the neutral rate will be appropriate." According to the ECB's own projections, inflation doesn't converge to its 2% target even in 2024.

The benchmark policy rate for the euro area implied by the well-known Taylor Rule is, in fact, around 3.40%. While it may seem unlikely that the ECB will raise rates that high in the current cycle, the rule highlights the scale of the challenge the monetary authority faces. More importantly perhaps, it shows that risks are skewed to the upside.

All the above mean that two-year German bonds, whose yields have already surged almost 200 basis points this year, are not done with the phenomenal selloff. In fact, the yield may ascend to 2.50% and beyond by the middle of next year should the ECB continue with its tightening as priced by the markets.