Eurozone recession risk and bond yields

Eurozone GDP fell 0.1% quarter-on-quarter (QoQ) in 2023 Q3, below market expectations of 0.2% growth (see Chart 1). More importantly, the latest GDP data is lower than projected by the ECB in September. Furthermore, the decline in the composite PMI index in October suggests that the risk of a technical recession, defined as two consecutive quarters of negative growth, is high.

Chart 1. PMI composite and GDP growth

Source: LSEG Data & Analytics and EFGAM calculations. Data as of 07 November 2023.

If this scenario materialises, average GDP growth in 2023 would reach at most 0.4%, much less than the 0.7% expected by the ECB in September. Furthermore, the negative carryover into next year makes the central bank's estimate of a growth rebound to 1% optimistic.

The weakness of economic activity during the summer is not surprising and reflects, together with other factors, the tightening of monetary policy that began twelve months earlier. The slowdown in the economy is necessary to rebalance supply and demand and encourage inflation to return towards the 2% target.

A case in point is the decline in headline inflation to 2.9% year-on-year (YoY) in October, although core inflation remains high at 4.2% YoY (see Chart 2). The ECB's seasonally adjusted data show a sharp slowdown in the most recent monthly changes in both non-core prices - food and energy - and core prices, which are the main focus of the central bank.

Chart 2. Eurozone HICP and PPI inflation (YoY)

Source: LSEG Data & Analytics and EFGAM calculations. Data as of 07 November 2023.

In the last three months, the monthly growth in core prices points to a return of inflation to close to 2% in mid-2024, almost a year earlier than projected by the ECB in September. This scenario is also supported by the double-digit decline in the producer price index (PPI) for manufactured goods and the stagnation of the PPI for services.

The monetary tightening initiated by the ECB in July 2022 is therefore likely to have peaked. If indeed the eurozone slips into recession and inflation continues to fall, it would be normal for the ECB to reduce interest rates as early as next year. Ultimately, self-flagellation is not a monetary policy strategy.

If history repeats itself, we would expect short-term interest rates and long-term government bond yields to fall in the coming quarters (see Chart 3).¹ In four of the six eurozone recessions that have occurred since 1970, both short-term interest rates and long bond yields have fallen, with the former decreasing by more than the latter. One exception was the recession in the late 1970s that followed the second oil price shock, when central banks prioritised fighting inflation over supporting growth. The other exception was during the pandemic when interest rates and bond yields were both already negative prior to the recession.

Chart 3. EMU benchmark yields and recessions

Source: LSEG Data & Analytics and EFGAM calculations. Data as of 07 November 2023.

As a result, the slope of the curve, measured as the difference between the 10-year government bond yield and the 3-month interest rate, would steepen and turn positive (see Chart 4).

Chart 4. EMU benchmark yield curve slope and recessions

Source: LSEG Data & Analytics and EFGAM calculations. Data as of 07 November 2023.

In conclusion, with the eurozone economy likely heading towards a recession and inflation falling, the ECB has no need to raise rates further and will start discussing rate cuts by mid-2024. As a result, it seems likely that bond yields will fall and the yield curve will progressively steepen in the coming quarters.

¹ Short-term interest rates and German government bonds are considered here as benchmarks for the eurozone.