Following the ECB December meeting, which brought strong hawkish surprise, we woke up to headlines of markets now more firmly signaling recession for euro zone, given that German yield curve has inverted. These articles we accompanied by graph showing inversion between 2yr and 10yr yield curve reaching levels not seen in decades. Among other places, here is FT from Dec 16th:
Of course, the movements in the yields after the ECB meeting
were not in any way driven by expectations of coming recession. The 2yr yield jumped
by 25bps (a 6-sigma event, apparently) on the day of the meeting, and surged by
further 20 bps since then. The 10yr yield also increased, albeit by smaller 14bps
on the day, and since then by further 30 bps. This is hardly the stuff preceding
recessions. Aren’t yields supposed to go down in recessions?
The story is the same as in U.S.. The ECB made it clear it
will go further above neutral then previously thought, with markets now pricing
further 125bps hikes or so in coming months. This will take the overnight rates
to around 3.25%, way above any reasonable estimate of long-run neutral rate. By
simple arithmetic in the form of expectations hypothesis, this means much
higher 2yr yield than 10yr yield, since policy rates will be above neutral only
temporarily.
So no, markets are not suddenly signaling recession in euro
zone. They are just signaling that the central bank will take rates further above
neutral and stay there longer. Of course, this makes recession more likely – my
subjective recession odds have increased on the day – but that is not what is behind
the market moves.
