Germany buys a 1st class ticket on the Titanic
Angela Merkel continues to resist the idea of a common Euro-zone bond as it increases the bailout burden on Germany. This has to be a bluff as the alternative would be an exit from the Euro. In addition to the utter chaos and years of dysfunction that a collapse of the Euro will bring to the financial markets, the return to a very strong Deutsche Mark (DM) would effectively kill Germany’s competitive advantage within and outside Europe in the long run.
Recently, the debate around how much Germany should do has morphed into a concern over whether Germany itself risks being caught in the contagion. This follows a “failed” 10 year auction last week where only 65% of the supply was taken up*. If Germany is having trouble funding, how long will it be before the market stops lending to the US? After all, the US is more in debt than core Europe combined. Italy, Spain, France, Germany and the UK** have roughly $8trillion of debt, whereas the US alone stands at over $10trillion. It may well be that the “can” (of debt) that has been kicked around for the past few years has started to kick back.
However, today, the markets are rallying strongly on rumours that the IMF will lend Italy some $600bn at 4-4.50% (well through their current market yields north of 7%) for a couple of years, to allow the EU leaders to put in place a longer term solution. For this rally to continue the rumour has to come true and there have to be concrete sensible measures from Germany for a viable Eurobond financing regime. If there is further dithering, we may well see a severe market puke that will drive risk asset prices down markedly. Given Ms Merkel’s reputation of shifting 180 degrees on a stated political position, this may well be on the cards.
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*Last week’s failed Bund auction (where buyers bid for only 65% of the 10 years Bunds offered at 2%) was not an isolated event. In a typical German primary auction, the debt agency retains 15-20% of the debt all the time. Since 2008, Germany has seen uncovered auctions in one out of five times, however last week’s retention was larger than usual. Germany also does not grant dealers the “green-shoe” option that allows dealers to buy bonds at the auction price up to three days later. These factors indicate that “failure” is perhaps a harsh term to use for the auction results. Clearly the low yield of 2%, year-end concerns and general illiquidity also had a part.
Given the mood of the markets and the media, the auction results have immediately been interpreted as the “credit crisis reaching Germany”. Stock markets across the world fell further, bond yields have risen across the board and the world was firmly in the “risk off” mode. This is how “fear” works—it not only makes you see the glass as half full, but makes you “feel” that someone else will drink the rest. Please bear this in mind as you start filling your mattresses with cash withdrawn from the banks.
So far, the “failed” auction has not led to a relative widening of German CDS spreads (with the UK). To the extent, Germany does not sign up to the Eurobond proposal or continually guarantees the Euro zone, bunds will likely remain safe haven investment.
Source: IFR
**The UK technically is not part of the Euro-zone but a big fire in your neighbour’s estate is hardly going to stop outside your gates.