>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