Sunday, December 4, 2011

>GREED & FEAR (Stock Market): Financial Gangrene

Investors this week got a whiff of the ultimate logic of the core contamination trade. This is
that the longer the Eurozone crisis continues, the more likely that it ultimately affects
Germany’s own credit rating. GREED & fear refers of course to the “failed” German bund
auction yesterday. The auction of 10-year German bunds attracted bids totalling only €3.889bn
or 65% of its sales target of €6bn. As a consequence, the 10-year German bund yield surged
by 23bp yesterday to 2.15%.

This is the sort of market pressure that is likely to lead, sooner or later, to German agreement
to a more overt move to monetisation by the ECB. But the German demanded quid pro quo for
such a development will be a move to a more concrete fiscal union, as discussed here
previously. Still as this week’s bond auction makes clear, Frau Merkel cannot wait too long. For
otherwise Germany’s own credit will be undermined by the spreading disease caused by
Euroland’s fault line, namely monetary union without fiscal union. Still for now Frau Merkel has
continued to tolerate this financial equivalent of spreading gangrene. Thus, this week she
seemingly shot down European Commission President José Manuel Barroso’s proposal for
eurobonds. Merkel said in a speech before the Bundestag on Wednesday that “it is extremely
worrying and inappropriate that the European Commission is directing the focus to eurobonds
today,” and that it was false to assume that “collectivisation of debt would allow us to overcome
the currency union's structural flaws”.

Still the pressure continues to mount, even if the French-German bond spread has of late
declined. Thus, the spread between the 10-year French government bond yield and the 10-year
German bund yield, which rose to a euro-era record high of 190bp on 16 November, has since
fallen to 154bp due to a 33bp rise in the German bund yield over the past week (see Figure 1).
Investors should continue to focus on this spread. But they also now need to keep an eye on
the absolute level of bond yields, both in the case of the French and German ten year bonds.
This is because the time has now passed where it only made sense to look at spreads.
Meanwhile, it is becoming ever clearer that the contagion in the Eurozone sovereign bond
markets has been aggravated by the efforts not to trigger CDS payments in the proposed
private-sector “voluntary” Greek debt restructuring. The result has been to motivate banks to
sell their underlying bond holdings since they can no longer be sure that they can hedge these
positions. It is interesting whether this unintended consequence of the latest Greek bailout package has finally caught the attention of European policymakers. It probably has since it finally caught the attention of the editorial writers in the pinko paper today (see Financial Times article “In praise of CDS”, 24 November 2011). Still the damage has already been done.

To read report in details: FINANCIAL GANGRENE
RISH TRADER

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