Jean-Claude Trichet’s decision this month to keep interest rates unchanged will push Europe’s economy deeper into a recession, the region’s bond prices show. The European Central Bank President said Feb. 5 that following the Federal Reserve and Bank of Japan in cutting rates to near zero has “drawbacks” that are “inappropriate.” Even so, investors drove yields on two-year German bunds to the lowest level relative to longer-maturity debt since 1997 in a sign that they are betting he will have to do just that. “The bond market is telling the ECB they need to wake up to reality,” said Komal Sri-Kumar, chief global strategist at Los Angeles-based TCW Asset Management, which has about $118 billion in assets. “They didn’t do their job on time or adequately, and need to cut rates again as soon and as much as they can. They also need to start thinking of unconventional measures.” Trichet, 66, has resisted slashing the region’s main refinancing rate as fast and as much as his U.S., Japanese and U.K. peers even as the $12 trillion euro economy headed for its worst recession since World War II. While the ECB even raised the rate in July before reducing it 2.25 percentage points since October to 2 percent, the Fed began lowering its target rate as early as September 2007, cutting it by 5 percentage points to a range of zero to 0.25 percent. The Bank of Japan reduced its rate 0.40 percentage point to 0.10 percent. The Bank of England lowered its rate by 4.75 percentage points to 1 percent. ‘Further Steepening’ Yields on shorter-dated debt, which are more sensitive to the interest-rate outlook, tumbled relative to longer-dated bonds, as investors bet the ECB will lower borrowing costs. The central bank next meets on March 5, and is likely to lower rates to 1.5 percent, according to the median estimate of 29 economists surveyed by Bloomberg. The so-called spread between two- and 10-year German note yields, the benchmark government-debt securities for the euro region, widened to 198 basis points, or 1.98 percentage points, on Feb. 6 from 82 basis points a year ago. The average in the past five years is 72 basis points. It was 180 basis points today. The trend, known as a steepening of the yield curve, may continue, according to John Stopford, a fund manager at Investec Asset Management in London. “We are very comfortable with curve steepening trades, and so far that works very well for us,” said Stopford, who oversees about $12 billion as global head of fixed income at Investec. “Economic data look dreadful and the ECB will have to play catch-up. They can cut by another 100 basis points.” 1997 Precedent By contrast, the spread between U.S. Treasuries of similar maturity narrowed 69 basis points since reaching 261 basis points Nov. 13, which was the widest since October 2003. The last time the German yield curve was so wide was in July 1997, when the Asian crisis erupted and German unemployment held near the highest level since World War II. Instead of lowering rates that year, the Bundesbank responded by increasing them to shore up the deutsche mark and head off accelerating inflation. Now, two-year note yields are about 75 basis points less than the ECB’s main refinancing rate. They averaged 30 basis points more in the past 10 years. ‘Inconveniences and Drawbacks’ “I will not embark on further discussions of the inconveniences and drawbacks when you have a zero interest rate,” Trichet said at a Feb. 5 press conference in Frankfurt after the ECB kept its key rate unchanged. “But there are a number of drawbacks and we feel that we should avoid them.” ECB council member Ewald Nowotny, who is also Austria’s central bank governor, said he’s “not an advocate for zero nominal interest rates, which would mean negative real interest rates,” the Financial Times reported today. Trichet’s comments come as a recession engulfing 16 countries from Slovenia to Spain deepens. German unemployment rose to almost 8 percent in January. Spain, Portugal and Greece had their credit ratings lowered last month by Standard & Poor’s. Air France-KLM Group, Europe’s biggest airline, posted a third-quarter loss on Feb. 13 and said it will eliminate as many as 2,000 jobs as demand sputters. Saab AB, the Swedish maker of the Gripen fighter planes, said last week it had a fourth-quarter loss from writedowns and order delays. Gross domestic product in the region shrank 1.5 percent in the fourth quarter, the most in at least 13 years, the European Union’s statistics office said Feb. 13. It will contract 2 percent this year, the International Monetary Fund said Jan. 28. The U.S. economy will shrink 1.6 percent, the IMF said. ‘Steepening Trades’ “We are holding steepening trades at the very short end of the curve” because of the economic outlook, said Christian Zima, a fund manager at Raiffeisen KAG in Vienna who helps oversee about $300 billion of fixed-income assets. “There could be further steepening.” German bonds outperformed their U.S. counterparts this year, handing investors a return of 0.27 percent, compared with a loss of 3.12 percent from Treasuries, according to Merrill Lynch & Co.’s German Federal Governments and Treasury Master indexes. Trichet will probably use other measures to revive the economy without cutting the interest rate to zero, according to Investec’s Stopford. They may include quantitative easing, under which the ECB prints money to buy securities such as government and corporate bonds from banks. “There seems to be concern among policy makers about the benefit of cutting rates that far,” he said. “They might do another 100 basis points, but beyond that there’s not much they can do.” Coordination Question For the ECB to engage in quantitative easing, it would have to coordinate with the 16 governments within the euro region. “Any debt-purchase program implemented by the ECB involves risk-sharing between members,” said Jacques Cailloux, chief euro-area economist at Royal Bank of Scotland Group Plc in London. “That’s highly political.” The ECB isn’t alone in questioning the merits of lowering rates to zero. Bank of England Governor Mervyn King, 60, said Feb. 11 the effect on the economy of further rate cuts is likely to wane. “We’re getting to the point where the efficiency of further cuts is diminished,” King told reporters in London. “The monetary policy transmission mechanism is somewhat impaired. The closer you get to zero, the more that’s likely to be the case.” Inflation Concern Trichet’s concern is that cutting borrowing costs will stoke inflation, which the ECB is mandated to keep to less than 2 percent. The bank remains “very prudent and cautious,” he said Feb. 5 as “inflation rates are expected to increase again in the second half of the year.” While consumer-price growth decelerated to 1.1 percent in January, the slowest in a decade, inflation expectations as measured by the so-called five-year/five-year forward rate, a gauge Trichet described last year as “very, very important,” rose to 2.56 percent, from 2.37 percent on Jan. 15. Inflation is likely to remain under control as the recession damps price pressures, paving the way for even lower rates, said Andre de Silva, deputy head of global fixed-income strategy in London at HSBC Holdings Plc, Europe’s biggest bank. “The market already priced in a 50 basis-point cut in March, but the rate will have to go much lower,” de Silva said. “There’s a possibility that the next move will be in conjunction with quantitative easing.”

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