The falling cost of protecting against inflation in the German bond market portends a deeper slowdown in Europe’s largest economy, signalling the effects of the continent’s debt crisis are edging closer to the core.
The two-year breakeven rate, a gauge of inflation expectations, dropped to minus 0.44 percentage point for Germany from 1.04 percentage point a year ago, and has remained negative since the end of May. The rate reflects investors selling index-linked bonds in favor of regular securities because they reckon consumer prices will decline.
“Germany is most probably heading for a recession,” said Humayun Shahryar, chief executive officer of Auvest Capital Management Ltd., a fund company in Nicosia, Cyprus, overseeing $100 million. “We are going through a debt crisis in Europe, and massive global economic slowdown. I’m not sure how Germany will be able to escape that.”
As the biggest contributor to bailouts for indebted euro partners, the risk is that economic travails at home make it even harder to convince German voters to loosen their purse strings just as yields on Spanish bonds suggest the country will be next in line for a rescue.
German exporters Puma SE, Europe’s second-largest sporting-goods maker, and Siemens AG, the region’s largest engineering company, both said this month they are suffering from the debt crisis as sales and orders fail to meet expectations. Eight of the 17 euro nations are in recession.
The year-on-year growth rate for the German economy, which accounts for 27 percent of the euro region’s gross domestic product, has fallen for four consecutive quarters. It expanded an annual 1.2 percent in the first quarter, the Federal Statistics Office reported in May. That compared with a rate of 4.7 percent during the same period of 2011.
While the Bundesbank, the country’s central bank, said last week that the German economy probably grew moderately in the second quarter, aided by domestic demand, latest data show that the manufacturing and service industries are contracting.
The country’s inflation rate held at 2 percent this month after dropping to the lowest in 17 months in June, the Federal Statistics Office in Wiesbaden said on July 27. The rate stayed the same because more expensive vacation packages and higher motor fuel costs made up for falling food and clothing prices, the office said in its statement.
Breakeven rates are derived from the yield difference between nominal and index-linked bonds.
The yield on the 3.5 percent German note maturing in 2013, used for a two-year breakeven-rate calculation, has dropped to minus 0.08 percent today from 0.07 percent at the start of the year. The comparable index-linked bond yields rose to 0.40 percent from minus 0.80 percent, reflecting investors’ preference for nominal bonds which offer no protection against inflation, according to John Wraith, fixed income strategist at Bank of America Merrill Lynch.
“On the one hand, they are indicative of huge safe-haven demand regardless of returns,” said London-based Wraith. “But there is also a strong fundamental argument here. A sell-off in index-linked bonds and negative breakeven rates make sense if investors are expecting deflation.”
The cost of buying a derivative that pays out should the price of a basket of goods in the euro region cost less in a decade than it does today climbed 43 percent from the same period last year, according to data compiled by Bloomberg. Germany’s five-year breakeven rate dropped to 0.98 percentage point from 1.27 percentage points at the start of the year.
Two-year inflation swap rate linked to the euro-area harmonized index of consumer prices declined to 1.45 percent from 1.92 percent on Jan. 2. Five-year rate fell to 1.53 percent from 1.99 percent during the same period. An inflation swap rate is a financial bet that pays off according to the degree to which consumer-price index exceeds or falls short of the pre-specified level at maturity.
“Inflation expectations have come off quite significantly, and if you compare that with the 2 percent inflation target from the central bank, it suggests there’s no inflation fear in the next five years in Europe,” said Kari Hallgrimsson, the head of European inflation trading at JPMorgan Chase & Co. in London. “From that point of view, the ECB has room to move on the rate side.”
German business confidence fell to the lowest in more than two years as the debt crisis damped the outlook for economic growth and company earnings. The Ifo institute in Munich said July 25 that its business climate index, based on a survey of 7,000 executives, dropped to 103.3 from 105.2 in June, the lowest reading since March 2010.
Puma cut its 2012 sales and profit forecasts on July 18 and said it will close some stores and may also eliminate jobs after sales slowed in the first half. The slowdown was particularly noticeable in Europe, the Herzogenaurch, Germany-based company said in its statement.
Siemens said its solar-energy business struggled because of cancellations as countries with high solar-radiation such as Spain find themselves strapped for cash.
Moody’s Investors Service lowered the outlook on Germany’s AAA credit rating to negative on July 23, citing the risk that Greece could leave the euro and an “increasing likelihood” that countries such as Spain and Italy will require support.
Yields on Spain’s two-, five-, 10- and 30-year government securities climbed to euro-era highs last week amid speculation the nation will need a bailout to backstop its regions and banks. Italian 10-year yields rose to 6.71 percent on July 25, the highest since January.
German bonds underperformed their U.S. and U.K. counterparts since Moody’s changed its outlook, losing investors 1.13 percent while Treasuries and gilts dropped 0.4 and 0.6 percent, according to indexes compiled by Bank of America Merrill Lynch.
Germany is increasingly risky because of its status as the lynchpin of the euro, said Josh Rosner, a managing director at consultancy firm Graham Fisher & Co in New York.
He likened the situation to collateralized debt obligations that package bonds or loans into a pool of assets that are divided into tranches of varying risk and return.
“Germany is the super senior tranche in the euro zone CDO,” said Rosner. “Losses have now moved into that tranche.”