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Last Monday’s regional election in Schleswig-Holstein was seen as a key test of the country’s ruling coalition ahead of next year’s federal vote. Its humiliating defeat will fuel the uncertainty brewing over the French presidential poll and the untidy Greek elections. The resultant market volatility increasingly threatens Chancellor Angela Merkel’s delicate balancing act. The relentless austerity that she has had to push is partly the result of her own country’s economic success and highlights how far apart the eurozone is economically.
The result is that Bund yields have tumbled to record low levels as Germany is seen as the only safe haven in a dysfunctional eurozone family. This has caused its own problems, with 10-year government paper edging towards the 1.50% mark and 30-year debt returning little over 2.25%.
Investors can see the logic in such a scenario, but their desire to maximise their portfolio returns has seen a number of technically failed Bund auctions as they choose to eschew the ultra-low yields.
Germany’s winning formula has been based on a solid manufacturing sector and an economy in which financial services play a relatively minor role. Banks which take pride in their domestic focus, loyally serving a traditional role in the provision of industrial capital, have cocooned the nation from the worst of the storm. But this is a formula based on the performance of a small number of key exports, and the cost and availability of capital remains key to their competitiveness, neither of which are immune to the unsettled climate.
The shrinking public sector has depressed the covered bond market, causing the volume of Pfandbrief issuance to fall dramatically this year. At the same time, German investors face a squeeze on opportunity as a result of the ECB’s Long-Term Refinancing Operation. With France’s own political issues causing a narrowing of prospects there as well, they are simply going to have to wait for things to pick up.
The country’s real economic strength cannot be taken for granted while the gremlins of European politics remain ready to gnaw at her vitals. Those used to the quantifiable arena of yields, spreads and losses may be too quick to dismiss the nebulous field of political risk, and many strategists warn that in the current climate European investors are failing to price it in properly.
Germany’s hunger for stability has forced it to adopt the role of lender of last resort for a group of neighbours it regards as profligate. Yet this runs counter to its deep domestic instincts and remains an enduring source of unease. So far, Merkel has been able to manage this tension. But inflationary pressures, combined with the ECB’s inclination to cut interest rates to help southern Europe, continue to assault the nation’s hawkish reflexes towards rising prices. The conservative camp fears that the strategic vision of deficit reduction is under siege while the broader public sees no reason to moderate its disillusionment with the European project.
Ultimately, it may be what happens next door – and in particular in France and Greece – that nudges this tension towards breaking point.