Wednesday, 23 November 2011

Bunga Bunga Bund?

Germany today held one of its regular auctions of government securities, an auction that turned into what was reported to be a ‘disaster’. There were no explosions and casualties, but the event highlights another stage in the worsening economic and financial crisis. Germany, the euro area’s richest and most powerful member, could not borrow as much as it planned to. How much worse is it going to be for the other members, or indeed for all heavily indebted countries?

Occasionally it happens that a government auction of securities does not attract enough investor finance. This can occur when financial markets are in turmoil and decide that the price is not low enough. However, usually the government is aware of the problems and the auction is managed ahead of time. In general, the volume of bids received is more than what is on offer. Even if the bids fail to reach the planned auction size, when things go wrong, then the rare shortfall is only on a small scale.

This time, however, investors only bid for 65% of the €6bn of new 10-year bonds on offer, and some of those bids were much lower than the government would accept! The end result was that the government only sold 61% of what it had planned, leaving it holding the remaining €2.36bn unsold bonds. This size of deficit is extraordinary; there has been none as large since before the launch of the euro in 1999.

The deficit may reflect the fact that German 10-year yields had fallen below 2% and so were unattractive to private investors. Yet, the yields had fallen so low because Germany was always seen as the ‘safe haven’ in Europe, at least within the euro financial system. In the crisis, German yields would fall as the yields on the bonds of the weakest countries rose. Collapses in global equity markets also encouraged funds to flow into bonds: better a low yielding bond than losing as much as 10% in a week in equities. But the failed auction is more likely to signal that Germany will now find that it has less ability to be favoured by capital markets given that it is seen as the paymaster for a system drowning in debt.

Germany’s 10-year yield rose by nearly 15 basis points (hundredths of a percent) today. Clearly this is not a big move in absolute terms, and it still leaves the yield level at close to 2.1%, while the euro’s currency value fell by a little over 1% versus the US dollar, again nothing drastic. But this event could prove to be a turning point for the euro system because it can be seen as a clear warning to the German government.

Current euro area policies are evidently not working to resolve the troubles of highly indebted countries like Greece and Italy, but they may also now begin to impact Germany itself. One other indication is that since the summer, the cost of insuring against a German government default over the next five years has risen from relatively negligible levels of around 40 basis points – a level in place since 2010 - to close to 100 basis points. However inaccurate, biased or irrelevant you may think Credit Default Swap insurance prices are, they are now two and a half times higher than before, a fact that will not have escaped the German authorities.

This trend cannot persist, and at some stage in the coming three-to-six months it is likely to provoke a reaction.[1] If Germany stays as the implicit guarantor of the euro, but does nothing to formalise this position through an explicit political commitment, then it will face a euro crisis that will get steadily worse, both for other member states and, more importantly, for itself. So it must either explicitly ‘opt out’ of the euro commitment, which means risking the break up of a political and economic project from which it has benefited greatly in the past two decades, and to which it still proclaims commitment, or it must agree to some version of euro-wide bond guarantees or financing by member governments. So far, the euro policy hierarchy has made laughable suggestions of leveraging the funds of the European Financial Stability Facility, when the EFSF itself cannot borrow in the market and the scale of its funds, even after the proposed leveraging operation that remains imaginary, will prove inadequate. The reason for the prominence of technocrats at all levels of euro politics is that the key politicians have not made, and perhaps cannot make, a decision.

One interesting crisis that may be on the near horizon concerns the European Central Bank. So far, the ECB has bought tens of billions of euros worth of government bonds issued by Greece, Italy and other member states. This is unusual, but allowed within its existing mandate. The orthodox argument is that this is providing liquidity, or ironing out unjustified market moves, even though it acts to try to neutralise the operation of the market that forces yields higher. The ultimate sin that the ECB has not yet committed, and which goes against the current rules, is to buy bonds directly from governments. Its purchases have been in the ‘secondary market’, ie after the bonds have already been sold. If the ECB moves to buy bonds directly from governments, for example by taking part in government bond auctions, then that will be monetising debt – creating money to pay for government deficits. Such a move is under way already by the US Fed and the Bank of England, with limited controls so that the pretence can be made that it is not really (much) monetisation. It is hard to see Germany allowing this option, but who knows, if push comes to shove, and the next few Bund auctions do not attract enough buyers?[2]

Tony Norfield, 23 November 2011

[1] I say 3-6 months because things are happening so quickly that what you think could take up to several years of agonising will probably occur much faster! From a market point of view, there are pressure points that usually occur in the lead up to year-end (ie now) and also in February-March, when a wide range of companies and various financial institutions make their forecasts and business decisions for hedging and investment. Two of those trigger points are within the next six months.
[2] The usual media commentaries about a German phobia of inflation always relate back to the post-World War 1 hyperinflation. I have found this implausible. The fact remains that the hyperinflation period was in the early 1920s, so anyone alive now (not many!) who actually remembers that is probably around 100 years old. This is not a plausible national memory for today, despite there being some German museums (always covered in TV explanations) that illustrate the ‘wheel-barrow’ money of the time. An important, and more recent bout of inflation that never gets much attention is the inflationary Nazi policy during WW2 that was one factor behind the replacement of the Reichsmark in 1948. Or perhaps the German anti-inflation sentiment is a result of the austerity and low incomes of the first decade or so after 1945 – with the view that higher prices would drive real incomes lower still? Any views or information on this would be welcome!

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