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The US dollar is a bit heavier against most foreign currencies as risk appetites across the board appear to have strengthened. Global equities are mostly higher. Core bond markets are also a touch heavier. Spanish and Italian 10-year yields were flirting with the 7% and 6% levels but have since pulled back (however note that Spain’s 2-year yield is up 22 bp to push through the 5% level). It is not about the news stream so much as the disappointing UK retail sales (0.1% in June rather than the 0.6% consensus forecast) has not stopped sterling from trading at its highest level since July 3 or the FTSE from rallying or supporting the gilts. The factors being suggested that have bolstered the risk appetite seem a bit of a reach and examples of post hoc narratives. There is heightened speculation of new measures by China, such as a cut in required reserves. Yet a surprise rate cut earlier this month did not reanimate the animal spirits. There are reports indicating that the draft of the memorandum of understanding for Spain has the EFSF setting aside some aid funds for buying Spanish sovereign bonds. This too does not sound auspicious, but rather plays into fears that the bank aid will morph into a full fledged assistance program.
Yesterday, for the first time, Germany auctioned 2-yer notes that produced a negative yield in the primary market. Germany is not alone seeing negative yields. At least five countries presently have negative yields on 2-year sovereign paper: Germany (-6 bp), Netherlands (-2 bp), Finland (-3 bp), Denmark (-37 bp) and Switzerland (-54 bp). A couple of other countries seem close to negative yields. Austria (2 bp) and France (7 bp).
To simply say these countries are safe havens may make analysis superfluous. It may help to conceptualize the negative yields as insurance against a euro zone break up. One might be willing to accept negative yields on the grounds, for example, that if the euro zone were to disintegrate, these counties would likely see a marked appreciation of their currencies. This also has implications for how far negative rates can go.
This conceptual framework suggests that if the fear of disintegration increase, yields can go much more negative. If one expects the euro zone to break up, it seems reasonable to expect the new German mark (not the old Deutschemarks that have not been exchanged which is the subject of various press reports) to appreciate by more than 0.06%. France is less clear. We have argued that France shares more in common with southern Europe than Northern Europe. If the euro zone disintegrates, would the new French franc appreciate or depreciate? We suspect the latte, given its external deficit, pre-euro behaviour and President Hollande aligning French interests with those of Spain and Italy.
We have drawn parallels between what is happening in the euro area as a whole and the struggle Madrid is encountering trying to rein in the regional fiscal excesses. In recent days, Rome has expressed concern about the sustainability of Sicily’s fiscal position. A new parallel is emerging. This one in Germany. Germany has 16 states, four of which finance intra-German transfers. Bavaria, which has been run by the CSU (the sister party of Merkel’s CDU) since 1949 (as long as the Communist Party has dominated China). Elections are scheduled for next year and the CSU is facing what appears to be an uphill battle.
The premier, Horst Seehofer, has logged a complaint with the Constitutional Court over the redistribution in Germany. Bavaria pays for about 50% of the roughly 7.3 bln euro in internal transfer payments in Germany. Baden Werttemberg and Hesse pay almost 25% each with Hamburg picking up 1%. The transfers are rooted in the German constitution which guarantees citizens in all the states to have uniform living standards and reports indicate Bavaria itself helped negotiate the terms of transfers over a decade ago.
However, Seehofer’s rhetoric (purposely?) echoes Merkel and Schaeuble’s rhetoric about the euro area as a whole (imbalances within the system and need for the debtors to address their imbalances). Seehofer argues some states have done nothing to reduce their indebtedness or live within their means. If some parts of Germany are not sufficiently “German” for Seehofer, can parts of Spain or Italy or Greece ever be? Today the lower house of the German parliament will likely approve assistance for Spain, but the consent will be due to opposition support. Even though Merkel’s poll ratings have risen, it is not clear she can command the majority of her party.
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