Euro zone government bond yields fell on Tuesday after a survey in Germany and France provided some recessionary signals that might challenge expectations that interest rates will stay at high levels for an extended period.
Business activity took a surprise turn for the worse this month as demand fell in a broad-based downturn across the region, a purchasing managers' survey showed.
Germany’s 10-year yield, the benchmark for the euro area, was down 4.5 basis points (bps) at 2.82%. It hit 3.024%, its highest level since July 2011, in early October.
Banks curbed access to credit in the third quarter even as demand from households and companies fell more than expected amid high borrowing costs and a deteriorating economic outlook, a European Central Bank survey showed on Tuesday.
The euro zone’s borrowing costs have recently tracked moves in U.S. Treasuries, with the run-up in yields on the 10-year U.S. note driven by investors pricing in more robust U.S. growth and fiscal slippage.
Some analysts said most of the recent bond sell-off came from the removal of recession risks and the correlated rise in long-term expectations for interest rates in the U.S.
Such a move triggered a narrowing of curve inversion on both sides of the Atlantic. An inverted curve, usually a reliable indicator of a future recession, means markets are pricing in events that would trigger central bank rate cuts.
The gap between Germany’s 2-year and 10-year yields was at -32.5 bps on Tuesday, after hitting its highest level in more than six months at -20.9 in early October.
Investors' focus will soon shift to the ECB policy meeting due on Thursday. Analysts expect the central bank to leave rates unchanged while reiterating they will stay at high levels for an extended period.
INFLATIONARY PRESSURES
Some analysts fear geopolitical tensions might fuel inflationary pressures, leading central banks to tighten policy further, but they don’t expect the ECB to make such a move before early next year.
The ECB is closely watching the unfolding situation in the Middle East, policymaker Gabriel Makhlouf said on Tuesday.
Oil prices were broadly stable, but investors remained nervous that the Israel-Hamas war could escalate into a wider conflict in the oil-exporting region, causing supply disruptions, which might trigger a further rise in prices.
Ruben Segura-Cayuela, European economist at BofA, said in a research note he expected the ECB discussion on the economic outlook to centre on "the move in energy prices, which risks leading to higher headline inflation than the ECB is forecasting" and the movement "in real yields."
Money markets priced less than a 20% chance of an additional rate hike by year-end and rate cuts in 2024.
Italy’s 10-year yield, the benchmark for the euro area periphery, fell 3 bps to 4.80%.
The spread between Italian and German 10-year government bond yields - a gauge of the premium investors ask to hold debt of the euro area’s most indebted countries - was at 197 bps, after hitting 193.6 bps, its lowest in a week.
Expectations that the ECB will be cautious on ending reinvestments from the Pandemic Emergency Purchase Program (PEPP) earlier than the current deadline at the end of 2024 are supporting peripheral bonds.
ECB President Christine Lagarde called PEPP reinvestments the first line of defence against so-called fragmentation - an excessive yield spread widening between core and peripheral bonds, which might hamper the smooth transmission of monetary policy across the euro area.
