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Investors in German debt are increasing their bets that the European Central Bank’s interest rate rises will push the European economy into a deeper downturn, as a closely watched recession indicator hit its most extreme level since 1992.
The gap between 2-year and 10-year German bond yields, which serve as the eurozone’s de facto borrowing benchmark, reached a 31-year low on Tuesday of minus 87 basis points, as markets repriced for higher interest rates despite recent signs that the eurozone economy is cooling.
The differential widened after Christine Lagarde, president of the European Central Bank, on Tuesday called for “persistent” high interest rates to kill off a second phase of inflation fuelled by rising labour costs.
When longer-term yields sink lower than shorter-term counterparts, markets normally have increasing conviction of economic trouble ahead that will prompt rate cuts in the future. In the US, the inversion of the Treasury yield curve is closely watched because of its record in predicting recessions.
“The message that is coming is pretty clear” said Lyn Graham Taylor, a senior rates strategist at Rabobank. “The market believes that the ECB will be determined to stick with higher rates and markedly slow the economy by doing so.”
Germany’s yield curve has become increasingly inverted as more hawkish messaging from the central bank convinces traders to bet on rates staying higher for longer.
Swaps markets are now pricing in a peak ECB deposit rate of 3.9 per cent by December, compared with projections of a peak of 3.7 per cent in October before its rate-setting meeting on June 15.
The yield on 2-year German debt, which is sensitive to interest rates expectations, rose 0.07 percentage points to 3.15 per cent on Tuesday, while 10-year yields rose 0.04 percentage points to 2.34 per cent.
Expectation for higher rates comes as economic clouds loom over the eurozone. The bloc is already in a “technical recession”, with gross domestic product contracting by 0.1 percentage points in each of the past two quarters.
Lagarde reiterated at the ECB’s annual conference on Tuesday that the central bank would keep interest rates “sufficiently restrictive” for “as long as necessary” to prevent a wage price spiral.
The ECB’s latest projections show it expects wages to grow by 14 per cent between now and the end of 2025. Eurozone annual inflation is expected to drop to 5.6 per cent in June when fresh price data is released on Friday — still well above the ECB’s 2 per cent target but down from a peak of 10.6 per cent in October as energy and food prices continue to slow.
George Buckley, chief European economist at Nomura, said the deepening yield curve inversion could be showing that Europe has suffered a series of shocks that have yet to feed through to the wider economy.
“Rewind nine months ago, we were standing on the edge of an [economic] abyss, the outlook was really awful,” he said. “The market could be saying the recession that hasn’t really happened is yet to happen and will hit,” he said.
However, he added that another interpretation is that price momentum is already slowing substantially, especially when you look at producer price increases and a slowdown in manufacturing.
The benchmark purchasing managers’ index, a measure of activity in manufacturing and services, for example, fell to a five-month low of 50.3 last month, below the 52.5 forecast by economists.
If prices continue to fall and wages remain strong, Buckley said it is possible that the ECB could bring rates down without triggering a deeper recession. He added that this is the base case of many economists, who forecast a lowering of inflation and return to economic growth and lower interest rates.
“You could not make up a more perfect scenario than that, and it makes me worry that we won’t get it,” he said.
