Euro Debt Magic- nothing up das sleeve
The European debt struggle may have just entered a new phase. Don’t blink. Like any classy magician’s trick the idea is to get you looking one place while the real action is going on somewhere else. And that has been the recipe over the past week or so. While everyone has been watching the Spanish and Portuguese debt auctions, with an eye on Italy, and while their bond prices drifted lower and yields drifted higher, the real damage was done in Germany where the German government’s bid-cover ratio on a ten-year bund auction came in less than ‘one.’
The bid cover ratio was not just low, it was less than unity. There was less than one euro bid for each euro of bond auctioned. The German government, while auctioning off the ‘safest bonds in the Zone’ could not sell them all even during a time of stress in the Euro zone.
This is a very interesting development. German 10-Yr bonds compete with US 10-yr notes that are at a 2.03% yield at the moment; at 1.77% the German auction produced a yield even below that in the US and the lowest yield on record for Germany. But it was a yield so low that not enough wanted the bonds any more.
What is this conundrum? If other bonds are so risky that there is a flight to quality how come the flight to quality can’t get off the runway?
The stupid magic trick that is at work here is the realization that a purchase of German bunds is not free of the risk of a purchase of Spanish or Portuguese government debt! Think ricochet! While Germany may be relatively safer than everyone else in the Zone it is still in the Zone and when things go wrong Germany will be tapped to cough up more resources. So Germany is not a pure play in the flight to quality since there is a feedback loop for distress. There is further feedback loop: through the German banking system that is heavily lent up throughout the Zone. It needs more help the more that the rest of Europe ‘goes wrong.’ And if the ECB puts its balance sheet at risk that too brings more risk to Germany as it is a member of the ECB.
While bund yields are below US Treasury yields, US treasury yields are still very low and the US economy is still growing quite solidly unlike Germany where bonds have not only a flight to safety effect going for them but also benefit from recession risk-pricing. Despite all that, Germany was not able to sell all the bonds it wanted to sell at auction.
Since Germany is the financial rock of Europe, its stable base, we have to wonder how stable it is – really –and the rest of the Zone too. At least the failure came at record low yields instead of at high yields. Even Spain and Portugal are selling their debt after all. But this episode reminds us that the e-Zone is a system and in a system there is dependency and there are interrelationships. And this is a point I keep trying to make in different ways. Europe problems are not as simple as German-Good, Greek-bad.
The ECB is making noises that it could start up its bond purchase program again – and that is something that will further deteriorate the ECB balance sheet and aggravate the Germans even as it might help the ‘Portugals’ sand the ‘Spains’ of the Zone.
It’s a good time to keep an eye on Europe, on everyone, since everyone is connected. The BIG MISTAKE that the Germans made was really in pursing their own interests too aggressively. There is something called ‘enlightened self-interest’ and the Germans do not seem to have it. In Japan there is a widespread recognition that you do not want to beat anyone too badly because in any arrangement there is a need to save face especially if there is an ongoing relationship. If there is no room to save face then bad things happen. Bad things are happening in the E-Zone, in part, because Germany has pressed its advantage too aggressively; it did not see the adverse repercussions from its banks over-lending to over-indebted countries nor did it see the repercussions politically of being locked in the same Zone with uncompetitive high-debt neighbors. This is classic case of: Oops there goes the neighborhood, meets, hey, I have a house in this neighborhood!
The Germans focus on their ability to export and by running persistently lower inflation than everyone else they rule that domain. But Germany rules it with such dominance that they themselves are now suffering the blow back from their own success which has undermined their neighbors’ abilities to fend for themselves.
I know a lot of folks just want to laud Germany for their great effort, productive economy etc. but THAT MISSES THE POINT. Germany is a cog in a system. It must mesh; play nice with others. The failure of the Euro system is a failure on the part of all the members. And the German failure is as severe as that of any other member. And we are now seeing the repercussions of Germany not thinking through the implications of its own policy. Actually it’s not a magic trick at all it is a systemic result from a system that has been poorly put together and poorly run.