European government bond yields fell to multi-month lows Wednesday, following yesterday's moves in U.S. Treasuries that have ignited concerns over the prospect of recession in the world's largest economy, as investors continue to pull away from risk markets and test the Federal Reserve's resolve on future interest rate hikes.
Benchmark 10-year German bund yields, a proxy for risk-free borrowing rates around the single currency area, fell to 0.25% in early Wednesday trading, the lowest in six months, taking the extra yield investors would earn to own U.S. Treasury notes instead to around 266 basis points. That spread could compel international investors to drive more cash into U.S. bond markets, lowering yields further and challenging the Fed's stance that "gradual" rate hikes are still appropriate for a growing economy and a tight labor market.
The moves in German bunds followed data showing private sector economic activity around the region eased to the slowest pace since September 2016 as global trade concerns and political uncertainty bear down on European business sentiment.
"Business optimism is running at its lowest since late 2014, adding to downside risks for growth as we move into 2019," said Chris Williamson, chief business economist at IHS Markit. "Furthermore, hiring, which has hitherto shown surprising resilience as firms have hoarded labour despite the slowdown in demand, is now also showing signs of weakness."
Falling European bond yields are likely to increase the flow of investor capital into U.S. Treasuries, which offer much higher returns with no added risks. That, in turn, will raise U.S. Treasury bond prices and lower their yields, adding to pressure on the so-called "yield curve" -- or the difference between 2-year and 10-year note returns -- and leading to a possible inversion.
Last night, the gap between 2-year and 10-year yields narrowed to less than 10 basis points, or 0.1%, the lowest in more than a decade, fueling concerns of a near-term recession. According to a study from the San Francisco Federal Reserve, an inverted yield curve -- where 2-year note yields rise higher than 10-year note yields -- has preceded all of the nine recessions the U.S. economy has suffered since 1955, making it an extremely accurate barometer of financial markets sentiment.
New York Federal Reserve President John Williams told reporters yesterday, however, that he was "still of the view that with the economy on a very strong path with a lot of momentum, especially with some of the fiscal tailwinds and other factors, that further gradual increases over the next year or so still makes sense."
Investors aren't quite as convinced of that stance, however, as they were just a few weeks ago, and while the odds of a December hike are cemented at around 80%, according to the CME Group's FedWatch tool, a following move in March is pegged at on 39.1% -- down 6 percentage points from early November -- while a June 2019 hike is given less than a one-in-five chance.
Still, the broader economy remains healthy, and consumers are likely to head into the holiday shopping season in a robust mood as a result: the Atlanta Fed's GDPNow forecasting tool suggests fourth quarter growth is humming along at a 2.8% clip, an assessment that's improved from last week's tally of 2.6%, while economists are looking for a November non-farm payroll addition of 210,000 and annual growth in average hourly wages of 3.2% when the Commerce department reports on Friday.
Bond markets will remain closed today, however, to mark a National Day of Mourning for the passing of former President George H.W. Bush. The observance also means that planned testimony from Jerome Powell before the Senate's Joint Economic Committee will also be delayed, meaning investors won't get a chance to hear the Fed Chairman's views on the current bond market moves ahead of the Friday payroll data.
That said, some investors have suggested the media's focus on one specific portion of the yield curve -- the difference between 2-year and 5-year rates, which inverted for the first time in more than a decade yesterday -- paints an inaccurate picture of the bond market's signalling.
"The Fed believes a more appropriate indicator would be the spread between 3-month Treasury Bills and 10-year Treasury notes," said Charlie Ripley, senior investment strategist for Allianz Investment Management. "Thus, while the inversion between the 2-year and 5-year point of the Treasury curve is notable, the spread between 3-month Treasury bills and the 10-year US Treasury is still 50 basis points and it could be many months before we see that point of the curve invert."