Gas rationing and China slowdown stirs Eurozone recession fears

Government bonds across the region fall with investors spooked by energy crisis and Chinese attenuation

The German Parliament has passed a regulation to prolong operations of coal-fired power plants to compensate for reduced gas delivery from Russia via pipelines. EPA
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Fears of recession in Europe grew on Monday after eurozone government bond yields fell in response to China's central bank reducing key lending rates and the prospect of gas rationing in Germany.

Beijing's surprise reduction came after July's economic data proved unexpectedly weak, with factory and retail activity squeezed by its zero-Covid policy and Evergrande property crisis.

"There are two clear-cut drivers behind today's fall in yields, weak China data and concerns about the impact of gas supply disruptions on the German economy," said Rohan Khanna, research strategist at UBS.

Germany must cut its gas use by a fifth to avoid a devastating shortage this winter, its top network regulator said, as businesses and households brace for Europe's biggest energy crisis in a generation, the Financial Times reported.

Germany's 10-year government bond yield, the benchmark of the bloc, fell four basis points (bp) to 0.899 per cent.

Germany's two-year yields, more sensitive to central bank rate increase expectations, fell 2.5 bp to 0.588 per cent after briefly hitting the highest since July 22 at 0.643%.

Money markets are pricing in a 50 bps rise from the European Central Bank (ECB) at its meeting in September, in addition to a slight chance of a more significant rate rise.

Investors are waiting for the Federal Open Market Committee minutes on Wednesday and the Jackson Hole symposium next week, after Fed officials provided some hawkish comments despite US producer prices unexpectedly falling last month.

"The consistently hawkish Fed communication is not yet fully discounted in our view with markets looking for only 50 bp in September," Commerzbank analysts said in a research note to clients about the ECB's likely next move.

Italy to stay under ECB umbrella

Italy's 10-year yield fell 2 bp to 3.055 per cent, with the spread between Italian and German 10-year yields at 209 bp. It widened to more than 260 bp immediately after the collapse of Mario Draghi's government last month.

Analysts highlighted two factors behind the recent spread tightening. Firstly, the ECB's so-called first line of defence against excessive divergence among bond yields — Pandemic Emergency Purchase Programme (PEPP) reinvestments — provided significant support for the peripheral bond markets of Italy and Spain throughout last month.

Additionally, Italian right-wing coalition leaders said they would stick to European Union budget rules, easing some fears the country could distance itself from the bloc.

"In the summer months, the impulse to sell BTPs is very limited after reassuring remarks from right-wing coalition leaders and the ECB reinvestments," Mr Khanna said.

"But how long it will take to form a ruling coalition and what happens with the new government remain a big question mark. So we can see a new spread widening after the vote."

Updated: August 15, 2022, 12:43 PM
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