For most of this year, the story in Europe’s bond markets has been about inflation. Prices kept rising, the European Central Bank kept raising interest rates, and investors kept demanding more to lend money to governments.
This autumn, a new word may have entered the conversation: recession.
Eurostat’s Business Cycle Clock – a real-time tracker that maps the phases of an economy – showed the eurozone in a sharp slowdown at the end of the third quarter.
Some countries, like Italy, may have already entered a recession, while Germany and France are still facing a downturn.
So is the bond market pricing in the start of an economic contraction?
How bonds usually warn of a recession
When investors expect hard times ahead, they usually do two things.
They move their money to the safest borrower they can find, which in Europe is Germany.
And they bet that the central bank will soon cut interest rates to help the economy.
Both moves push German borrowing costs down. If a recession were really on its way, German yields would be falling.
They are not.
Germany’s 10-year yield stood at 3.49% on Thursday afternoon, up from about 2.85% at the start of the year. On 28 September, it reached 3.65%, its highest level in about 17 years.
The two-year yield closely follows what investors expect from the European Central Bank, and it is at 3.07%.
That is well above the ECB’s deposit rate of 2.50%. In plain terms, investors still expect rates to go up, not down.
“Bunds are still the natural benchmark investors look to when markets get nervous, so some widening against Germany is exactly what you would expect,” Ken Egan, head of European sovereign credit at credit rating agency KBRA, told Euronews Business.
“But it does not look like a full flight to safety, because Bund yields have not fallen materially,” he said.
The reason is energy.
The war in the Middle East has pushed up oil and gas prices. Eurozone inflation jumped to 3.8% in September from 3.2% in August, according to Eurostat, and energy prices alone were up almost 19% on a year earlier.
The ECB has already raised rates twice this year, in June and in September. Money markets expect roughly one more increase by December.
The real stress is in France, but it’s now broadening out
If the bond market is not pricing in a recession, where is the pressure?
The clearest answer is France.
France’s 10-year yield is at 4.88%, about 1.39 percentage points more than Germany pays. At the start of September, the gap was about 0.87 percentage points.
This gap is known as the spread. It is the extra price investors charge for lending to one country rather than to Germany, and it is the bond market’s way of measuring trust.
France now pays more to borrow than Italy, whose 10-year yield is 4.60%. Paris also pays about 0.5 percentage points more than Athens.
For most of the euro’s history, that would have seemed unthinkable.
The French budget deficit is expected to reach 5.4% of the country’s economic output this year. It has been above the EU’s 3% threshold for the past six years.
The government presented €43 billion of new savings on 1 October, but it is struggling to win support for them in parliament.
The Economist estimates that stabilising French debt at current borrowing costs would require fiscal tightening worth more than 4% of GDP – roughly ten times the savings lawmakers are currently debating.
France is the centre of the stress, but the pressure is spreading.
Italy’s spread over Germany has widened from about 0.84 to 1.12 percentage points since early September.
On Thursday, the Italian 10-year yield briefly touched 4.75%, its highest level in a year.
Spain’s spread over Bunds has also widened, to around 61 basis points, as the country heads to a snap general election on 29 November.
For Egan, the move “looks like a mix, and it is difficult to separate exactly how much of the move is France-specific.”
“A lot of the broader rise in yields reflects the energy shock and expectations for tighter ECB policy, but France clearly carries an additional fiscal and political premium,” he said.
Is this stagflation?
A genuine recession risk would leave clear fingerprints: the two-year Schatz yield dropping below the ECB’s 2.50% deposit rate, Bund yields falling as French, Italian and Spanish spreads widen together, and money markets swapping 2027 rate hikes for cuts.
None of that has happened yet.
“The traditional warning sign is an inverted yield curve,” Egan said.
“But once a recession is being priced in, the curve would normally start to bull-steepen as markets bring forward rate cuts.”
In other words, short-term yields would fall faster than long-term ones as investors bet on rate cuts.
Egan said Bund yields would also fall, periphery and credit spreads would widen more broadly, and purchasing managers’ surveys would move “decisively into contraction.”
“At the moment, that combination is not really there,” he said, noting that Bloomberg’s one-year euro-area recession probability of 20% “still points to elevated rather than acute risk.”
What markets are pricing in instead looks closer to stagflation, an economy losing momentum while inflation keeps climbing.
That scenario would leave the ECB with no good options.
Hiking further would squeeze indebted governments and a weakening economy. Pausing too early would risk entrenching inflation.
Winter could make things worse before they get better.
European gas storage was about 72% full at the start of October, according to Gas Infrastructure Europe, the lowest for the time of year since records began in 2011 and roughly 15 percentage points below the five-year average. A cold winter would tighten an already strained energy market.
“For the ECB, the difficulty is that inflation has moved back above target without the economy obviously overheating,” Egan said.
“If higher energy costs continue to feed through while market yields and financing costs are already restrictive, the casualty may increasingly be weaker demand and growth.”
So far, investors have sold European periphery bonds on inflation fears.
If they start buying Bunds on recession fears while still dumping French debt, the ECB will face the dilemma it has spent a decade trying to avoid.