Europe's benchmark risk-free interest rate slipped into negative territory for the first time in nearly three years Friday, following a worrying reading of manufacturing activity in the region's biggest economy, in a move that could exaggerate a key recession signal in the United States and complicate any policy response from the Federal Reserve.
Manufacturing activity in Germany, Europe's biggest economy, slumped to the lowest level in more than six years this month, according to a private sector reading from IHS Markit, with new orders falling to a 2012 trough. The index has now fallen for 14 of the past 15 months and raises the very real prospect of a recession that could ripple through to both the broader Eurozone economy and trade partners around the world.
"Uncertainty towards Brexit and US-China trade relations, a slowdown in the car industry and generally softer global demand all continue to weigh heavily on the performance of the manufacturing sector, which is now registering the steepest rate of contraction since 2012," said IHS economist Phil Smith.
The reading, which was paired by similarly weak assessments for France and the broader Eurozone, pulled benchmark 10-year German bund yields 5 basis points lower on the session to trade at an October 2016 low of -0.015%.
Bund yields are a proxy for risk-free interest rates in the Eurozone and a key metric for global investor sentiment. Negative yields in such a large market -- BIS data suggests all German-issued debt was pegged at €3.6 trillion last year -- inevitably push investors to search for higher returns in other markets.
U.S. Treasury bonds yields, by comparison, offer investors a yield-to-maturity of around 2.478%, allowing European bond traders to re-route customers into North American markets while simultaneously reducing credit risk.
Bank of America Merrill Lynch estimated Friday that an additional $12.1 billion has flowed into fixed income portfolios this week, and with negative yields in Germany and Japan, and near-zero rates in other developed markets, it's a safe bet to assume much of that cash has found its way into Treasuries.
Those moves act as an anchor for 10-year Treasury bond yields, which move inversely to prices, pulling them lower and reducing the gap between returns on 2-year Treasury notes, which are currently pegged at 2.381%.
That's a critical factor to note given that investors often gauge that yield gap, which now sits at at December 21 low of 10.5 basis points, as a precursor for near-term U.S. recession risk.
An inverted yield curve, a condition where 2-year yields rise above 10-year yields, has signaled nearly every U.S. recession for the past 60 years, according to Fed studies, and the last time it was marked near 11 basis points, the S&P 500 traded at an 18-month low of 2,351.10 points.
Another component of the flattening yield curve is the composition of the Fed's $3.8 trillion balance sheet, which includes a larger portion of longer-dated paper that helps hold down market yields for similar maturities. Fed Chairman Jerome Powell said addressing that would be a "consequential decision and one that needs some thought."
However, he also said that "in Europe we see some weakening, but, again, we don't see, we don't see recession, and we do see positive growth still."
Material recession increases in Germany, which would quickly spill-over into Europe, would likely necessitate a different interpretation from the Fed if the curve continues to flatten as a result, with potentially corresponding sales of bonds from its balance sheet in order to avoid and inversion.
"We've had a lot of balance sheet discussions, as I mentioned over the last four meetings, but this is the next big one that, big decision that we'll face," Powell told reporters Wednesday. "And, you know, I think we're not going to be in a rush to resolve it, but we'll turn to it soon."