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The plunge in German bond prices is not just an interest rate issue

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Yields on German bonds rose to 2.8% this week, the highest in 12 years and a whopping 35% higher since the start of the year. While most of the immediate bond weakness has to do with inflation and interest rates, Germany is also facing other deeper issues around confidence and trade relations.

The European Central bank has signalled that it might not raise interest rates again (they are already at an all-time high of 4%) but in light of consumer prices remaining stubbornly high there is a good chance that the bank will keep high rates in place for longer than expected.

Like long-Covid, the high rates are doing quiet damage to European economy, hurting the labour market, business confidence and bank lending and the central bankers are now expecting that the Eurozone economy will grow at a slower rate than they initially expected.

European inflation data scheduled for release later this week will shed some light on the situation and while the recent rise in oil prices may not have registered yet in the official data it is one of the factors that will keep inflation propped up in the last part of this year.


More than an inflation issue

Stepping away from the conversation about interest rates and inflation, there are several deeper issues at stake in Germany. Two are particularly worth mentioning.

The first is that ever since Angela Merkel stepped down as Chancellor the level of confidence in the German leadership has never fully recovered. Investors and the general population alike have less faith in how Merkel’s successor Scholz will handle crisis situations, and there are plenty of those at hand: the war in Ukraine, the influx of refugees into the country, energy supply issues.

Germany’s Ifo business confidence index is at its lowest in five months and the country’s economy is looking at risk of facing a second recession in a year. Unemployment figures are at their highest in two years, and that is saying something given that two years ago the country was still in a deep lockdown because of Covid.

Which brings us to the second issue – a significant deterioration in Germany’s relationship with China. This is a crucial piece of the puzzle because in the past it would have been one of the levers Germany would have used to strengthen its economy.

China is a major export partner and German exports into the country reached $113 billion last year. Germany has for years been a beneficiary of China’s economic development selling cars, machinery, electronic equipment and pharmaceuticals into the country.

However, China has been making concerted efforts to develop some of these goods at home, particularly strong EV brands, and with other goods it changed the terms of trade so that they are no longer favourable for Germany.

Germany’s falling out of love with China was formalised in July when the German government published its first ever China strategy document spelling out issues such as enhancing cyber security and looking for new global partners, for instance, India. The fallout from the rift is already visible in some of Germany’s economic indicators such as manufacturing PMI (39.8 in September, well below the 50 level which would signal expansion), trade and currency data.

Germany is by no means economically weak. But for the moment economic headwinds remain strong.

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This article does not constitute investment advice. Make sure you do your own research or consult a professional advisor.

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