German bond market warns of Eurozone recession

Investors in German bonds are increasing their bets on the European Central Bank raising interest rates, which will cause the European economy to go into a further downturn. A closely monitored recession indicator has hit its highest level since 1992.

The difference between the yields of German bonds for 2-years and 10-years, which are the de facto benchmarks used by the eurozone, fell to a new low of minus 87 base points on Tuesday, as the markets re-priced their interest rates in anticipation of higher rates, despite recent indications that the eurozone is cooling.

The difference widened when Christine Lagarde – the president of the European Central Bank – called on Tuesday for “persistently” high interest rates in order to stop a second wave of inflation fueled by rising wages.

When longer-term rates fall below their shorter-term counterparts the markets are more convinced that economic troubles will be ahead, which will lead to rate cuts. The inversion of the Treasury curve in the US is closely monitored because it has a good record of predicting recessions.

Lyn Graham Taylor is a senior rate strategist at Rabobank. She said that the message is clear. The market believes the ECB is determined to keep rates high and slow down the economy in the process.

The yield curve in Germany has become more inverted, as traders are now betting on higher rates for longer due to the central bank’s hawkish messages. The swaps market now prices in a peak ECB rate of 3.9 percent by December. This compares to projections that a peak rate of 3.7 percent would be reached in October, before the rate-setting meeting of June 15th.

The yield on German 2-year debt, which is sensitive for interest rate expectations, increased 0.07 percentage points on Tuesday to 3.15 percent, while the yield on 10-year German bonds rose by 0.04 percentage point to 2.34 percent.

The eurozone is facing economic clouds. The bloc has already entered a “technical depression”, as the gross domestic product fell by 0.1 percent points each of the last two quarters.

Lagarde said at the ECB annual conference on February 2 that the central banks would maintain interest rates for “as much time as is necessary” in order to avoid a spiraling wage price.

According to the ECB’s most recent projections, wages are expected to increase by 14 percent between now and 2025. Fresh price data will be released on Friday, and it is expected that the annual inflation rate in the Eurozone will drop to 5.6 percent in June. This is still above the ECB target of 2 percent but lower than a high of 10.6 percent in October.

George Buckley is the chief European economist of Nomura. He said that the inversion of the yield curve could indicate that Europe has experienced a series shocks which have not yet impacted the economy.

“Nine months ago we were on the brink of a [economic] abyss. The outlook was very bleak,” he said. He said that the market might be saying that the recession, which hasn’t happened yet, is about to hit.

He added that there is another interpretation that the price momentum has already slowed substantially. This is especially true when you consider producer price increases, and a decrease in manufacturing.

Last month, the benchmark purchasing managers’ indicator, which measures activity in manufacturing, and services, fell to a five-month low of 50.3, well below the forecasted 52.5 by economists.

Buckley stated that if prices continue to drop and wages remain high, it’s possible the ECB can lower rates without causing a recession. Buckley said that many economists believe this to be the case, and predict a return to economic growth as well as lower interest rates.

He said, “You couldn’t make up a better scenario than that. It makes me worried that we won’t get it.”