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German bond yields have proven to be a far more sensitive indicator of stress in the euro-system than the euro itself. As Europe rumbles towards another leaders’ summit, but one that has ‘urgency’ boldly emblazoned, the eurozone’s core bond market will tell us more about whether politicians are getting a grip on the crisis than any communique.
If they are, the market should drop like a stone, as flight capital reverses, returning money to other eurozone markets. It is reported several big hedge funds see Europe’s core bond market as an accident waiting to happen.
But haven’t we seen this play before? If German bonds are a ‘big short’ (as opposed to a trading short), you have to be persuaded of two things.
First, that the German bond market won’t go the way of Japan. The big short in Japanese government bonds has been a recurring theme among investors for over a decade, and still this stubborn market refuses to kowtow. One day, it might as the steady decline in aggregate savings arising from rapid ageing erodes Japanese savings flows and the external surplus.
But weak investment, high deposit flows, a strong yen, financial repression, and the risk aversion of Japanese investors are enough to keep this day of reckoning as a mirage for the time being.
Germany, also a creditor, external-surplus nation, with a deleveraging banking system may be no different. In some ways, German bonds look to be a better risk than Japanese government bonds (JGBs). It doesn’t have its own currency, of course, and foreigners own over 50 per cent of general government debt outstanding, compared with 8 per cent in Japan. But German general government debt is a third of Japan’s on a gross basis, and half on a net basis.
The German government’s gross sovereign financing needs are roughly 10-11 per cent of gross domestic product in 2012-13, compared with 58 per cent in Japan. Germany’s current account surplus is bigger, its nominal gross domestic product is still rising, and it is some way behind Japan in the demographic shift.
The relentless fall in German yields from the 1990-91 peak of nearly 9 per cent following unification may be largely over. But the fleeting increases in the 2009-2010 global economic recovery, and in 2010-11 as bailout packages for Greece, Ireland and Portugal were agreed, were not sustainable. The JGB lesson is generational lows in German bond yields are structural, not a valuation freak.
Second, without a random shock to global bond markets, German bond yields are only likely to trend or lurch up if European leaders perform a ‘giant leap’, most likely when Greece defaults and leaves the euro. They first agree the European Central Bank has to do ‘proper’ QE by lending to a bank-licensed European Stability Mechanism, whose debt would be mutualised. Widespread debt restructuring or forgiveness, economic growth initiatives and an agenda for faster budgetary and banking integration would all figure prominently.
By now, we know well how to fix the eurozone, but the political will to do so remains elusive. Even if the fiscal compact is pretty much done pending ratification, Europe needs an immediate change in the behaviour and operating remit of the ECB and ESM. To say nothing of e-bonds or debt restructuring.
Moreover, it is doubtful that banking union is ever going to happen, bar some changes, perhaps, towards greater pan-European supervision and prudential management.
Strong political vested interests at the national level are unlikely to allow resolution and restructuring authority to be ceded to European institutions. And as the Spanish bank rescue showed, European governments don’t like being told what to do about their weak banks, and don’t like putting money at risk directly in the form of equity. They also don’t seem to realise that the name of the game is to get private capital back into the financing game, not squeeze it out further, for example, by subordinating private creditors.
If the political divisions over the giant leap cannot be closed, then either the euro-system disintegrates as the mighty Deutsche mark re-emerges, or it fragments, as Greece and maybe others leave, limited integration for the remainder occurs in Teutonic fashion, while credit and currency risk endure. German bonds will stay underpinned therefore for a considerable time.
German bond yields will turn tail only if there is soon a vigorous demonstration of political will, and of German political will in particular, simply because Germany holds sway over most of the important compromises needed for existing monetary union to work.
And yet, we can have much empathy for the dilemmas, which Germany faces nowadays, and to which Angela Merkel alluded recently in her ‘But our strength isn’t infinite’ speech to the Bundestag. Unless you think she’s bluffing and biding time before caving in, German bonds are no big short.
George Magnus is senior economic adviser at UBS