It has been a difficult week for Germany. Instead of attributing the intensification of the crisis to the debtors, some officials and observers, as well as the media, are blaming Germany for not opening its purse more. Germany, we are told, is isolated, but it is not. The key division in Europe is creditor and debtor. For much of its resistance to a joint bond or a transfer union, Germany is joined by Austria, Finland and the Netherlands, the other creditor nations.
Another reason it has been a difficult week for Germany is that the safe haven bid for its debt seemed to evaporate even though Spanish and Italian yields rose sharply. The German 10-year yield finished last week near 1.33% and rose 20 bp by mid-week. The 2-year reached 15 bp yesterday up from 4 bp at the last week. This reversal is also evident in the credit default swaps market. The German 5-year CDS peaked near 120 bp in Q4 ’11. It fell back to around 70 bp in Q1 and this week has flirted with 110 bp.
Now that Spain has been offered a 100 bln euro backstop for its banks, many investors believe the breaking point is rapidly approaching. The muddle through approach cannot last much longer. There are two big risks: action and inaction.
Whatever they do, it has to be big and a quantum leap from the existing strategy. This is conceived as tighter and more complete union. This would entail a larger commitment from the creditor countries in exchange for centralized fiscal and financial authority. This would be a dilution of German credit, making bunds less attractive.
Alternatively, if nothing is done, or if something weak gesture is made, the euro zone disintegrates, or sufficiently so, that Germany is left with the costs of the unwinding, such as Target 2 imbalances, far in excess of its ECB weighting share. This too would undermine the attractiveness of bunds.
Remember, Germany’s current debt is a little more than 80% of GDP (it is interesting to note here that Spain’s debt/GDP at the end of last year about 68% of GDP). Some speculate that Germany is trying to sabotage EMU, but if it does break up, Germany will be a major loser, just as it a major beneficiary of the project. Its debt would quickly rise. If it were just to get stiffed for the Target 2 imbalances, it would see the debt/GDP ratio climb over 100% of GDP. Even with near record low interest rates and a currency that is relatively cheap for German exports, the German economy is stalling. Next week (June 21), flash June manufacturing PMI will be published. It will likely be the fourth consecutive month below the 50 boom/bust level. The 45.2 reading in May was the lowest since June 2009. Foreign demand appears to be falling sharply and more sharply that investors may suspect. Exports in April fell 1.7%, almost three times more than the consensus forecast.
If investors are beginning to feel less comfortably in Germany, given the two general scenarios, where are they going? It is difficult to tell, but there are a couple of likely candidates. In the past week, Norway seemed to be a likely destination. The Norwegian krona has been the strongest major currency over the past five sessions and its 10-year bond yield fell 29 bp over the same period to about 1.86%.
We recently noted that Denmark also seemed to experiencing inflows. This forced the central bank to accumulate more reserves to keep the currency in its desired band against the euro and cut interest rates. Flows seem to be attracted to Switzerland too. The Swiss 2-year yield was negative 2 bp on May 15. A month later it is at negative 32 bp. Swiss rates are negative through the 5-year duration.
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