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Friday, 01 August 2014

Watch German Bunds for euro fate

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The recent fall in German Bunds is the most interesting development in markets in months, and may contain hints of the fate of the euro itself.

James Saft, Reuters Columnist

German Bunds have sold off sharply in June, driving yields higher. In recent days they have also broken a longstanding relationship and are now falling along with Italian and Spanish bonds, rather than, as they have almost throughout the crisis, rising as things in the periphery get hairy.

Since June 1, benchmark German 10-year yields have risen by nearly a quarter to 1.42%. To be sure, German yields are still very low, and the rise in and of itself is meaningless to Germany’s ability to manage its debt and borrow.

Strikingly though, in recent days at least, what is bad for the debt of weak eurozone nations also seems to be bad for Germany.

This is either really good news or really bad news.

Since the beginning of the euro crisis investors have sought safe haven in German bonds. Some of this is, in essence, capital flight, as investors worried about being stuck with new drachmas or pesetas opt for the debt of one of the few eurozone states whose currency, were it ever to leave the euro, might actually rally.

Germany may soon blink and become the effective guarantor of the eurozone banking system and of the finances of its weakened members. That’s absolutely terrible news for Germany’s creditors, who will have no say in the matter, but excellent news for the rest of us.

The good news option is that investors are now waking up to the possibility that Germany may soon be a far, far worse credit. Germany, in other words, may soon blink and become the effective guarantor of the eurozone banking system and of the finances of its weakened members. That’s absolutely terrible news for Germany’s creditors, who will have no say in the matter, but excellent news for the rest of us.

A eurozone breakup, no matter how a soft exit or transitional period is spun, is terrible news. It would damage the European and global economy and might bring on yet another freeze in global capital markets. Therefore, if rising bund yields are signaling that it is becoming politically and practically possible for Germany to sign on as the eurozone’s backstop we all ought to give thanks.

A fine line between great and terrible

Sadly, a number of very terrible outcomes could also produce the same pattern of trading in markets, and at this point it is impossible to distinguish the good from the dire.

First off, the rise in Bunds might just be good old-fashioned contagion. German banks’ assets dwarf German GDP, and include very large exposures to potentially dubious borrowers on Europe’s fringes. Moody’s on June 5 downgraded seven large German banks and some subsidiaries, citing high leverage and risks from the eurozone crisis. A review of Deutsche Bank, Germany’s largest bank, is ongoing, Moody’s said.

Perhaps more to the point, the continuing deterioration in the eurozone points to rising risk of break-up.

“Yesterday’s rise in Bund yields, which was accompanied by simultaneous rises in Italian and Spanish yields, was particularly scary, in that it seemed to signal that investors were developing a generalised fear for the euro’s continued existence, and hence were selling the debt of all euro countries – large or small, safe or precarious,” Saxo Capital Markets senior markets consultant Nick Beecroft wrote in a note to clients.

“In the case of a widespread break-up of the euro, what is the value even of Bunds, denominated as they are in euros?”

“In the case of a widespread break-up of the euro, what is the value even of Bunds, denominated as they are in euros? Even though they may come to be redenominated in Deutschmarks, who wants to go through the legal hell and uncertainty that would surely ensue?”

While you might be better off holding German rather than Italian or Spanish bonds in the event of a break-up, there are many more attractive places to be.

Germany has done, it must be pointed out, very well out of the euro, which has provided a market for its products and kept its currency cheaper than it would otherwise have been. If the euro breaks apart, Germany will likely have to recapitalise many of its banks. It will also find that its tax receipts are hit drastically as Europe, and likely the world, fall back into a deep recession.

There is also the possibility that Germany finds itself, like Spain and Greece before it, the subject of a financing crisis but not the possessor of the tools to fight it. If, for whatever reason, Germany finds its yields rising sharply, it too will suffer because it does not have its own central bank with the right and responsibility to print money to meet its obligations. This, to put it mildly, would be a bit of an irony.

It is impossible to know if we should cheer German yields higher or run for cover.

For the next several months German 10-year yields might become the world’s most important number.

(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. You can email him at jamessaft@jamessaft.com)

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