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Eurozone tensions set to grow

Politicians and the general public in strong European economies like Germany are resisting the idea of a rescue operation for the weaker Eurozone countries. This will continue to have implications for bond yields.

The outlook for the ten-year yield on German Bunds – the European benchmark for long-term interest rates (swaps) – is important for long term investment and financing decisions. The outlook for the ten-year yield seemed, until recently, a one-way bet. With tensions rising in the European periphery, investors looking for a safe haven ended up buying German Bunds, with downward pressure on the yield as a consequence.

Over the last couple of months the German ten-year yield has gone up, yet tensions in the euro area have not dissipated. In our view, this upswing is understandable for a number of reasons:

  • The trouble in the Eurozone is far from over. Still, tensions have eased somewhat in the past weeks, mainly on hopes that the euro crisis will eventually have a happy ending. In our previous reports we explained that the strong EMU economies can either stand by as the monetary union disintegrates or provide help to the weaker members of the union on a large scale. The former would immediately trigger an economic depression; therefore the latter can be viewed as the lesser of two evils. Although major rescue operations within the EMU meet with a lot of political resistance – both in countries that are still doing well and in member states that barely manage to survive – Germany seems to be moving in this direction. Recently, capital has been flowing back from Germany towards the weaker euro countries.

  • The German economy is growing at full tilt. Not since reunification in the early 1990s has economic growth been this high, and a number of forward-looking indicators suggest that the economic engine will continue to perform in top gear. This pushes up the demand for capital.

  • The German economy is booming for a number of reasons. In the past years, Germany was one of very few countries in the West without skyrocketing property prices or a credit bubble, so the German economy has been comparatively unaffected by the credit crisis. German businesses are very competitive because wages have been slow to rise for many years. On top of this, German public finances are relatively healthy. In combination with high economic growth the latter means that the government does not need to make deep cuts. Finally, as mentioned above, a lot of capital has lately been flowing towards Germany from the problem countries in the EMU. This has depressed long-term interest rates and boosted economic activity.

  • The rate of inflation in Germany has risen, partly on high economic growth but also because of soaring energy, food, and other commodity prices. In addition, the state is pushing up inflation by raising duties and tariffs, while investors are aware that wage rises in Germany are increasingly outpacing inflation. This carries the risk of second-round effects. Rising inflation rates could drive up wage increases. This would lead to even higher inflation and feed into fears of inflation and/or monetary tightening.

  • US bond yields are up, which tends to push up German bond yields as well.

Resistance

In contrast, we believe that it is far too early to breathe a sigh of relief over the euro crisis. In our view the Germans will not easily decide to rescue the weak EMU members in a big way. There is a lot of resistance, among politicians as well as among the general public. This is the case both in Germany and in other euro countries that are still going strong, such as Finland and the Netherlands.

Speculation on the aforementioned ‘rescue operation’ has considerably narrowed the spreads between bond yields in the weaker and the stronger EMU members. This does not bode well for the latest aid plan that is being drawn up, as this entails that the strong countries lend money to the weak states so that the latter can buy back their own bonds at a large discount.

Owing to these factors we shortly expect heightened tensions in the Eurozone. In response, the German ten-year yield could start to drop again. In addition we foresee an economic downturn in the Eurozone as well, which would ease inflation (expectations). This too could send Germany’s ten-year Bund yield lower.

Implications

In such a climate (inflation not rising much further, a cooling economy, higher tensions in the EMU) the European Central Bank (ECB) is unlikely to raise its benchmark rate, as this might plunge the weak euro countries back into recession.

Chart 1: Dire situation in economically weak EMU-countries makes ECB reluctant to raise inrest rates
Chart 1: Dire situation in economically weak EMU-countries makes ECB reluctant to raise inrest rates

Source: Reuters EcoWin/ECR

In summary, we think the yield on ten-year German government bonds (now around 3.15%) will initially rise towards 3.5% before dropping towards 3% as stock prices fall and the US economy begins to slows.

Such a downswing should not be confused with the medium-term trend. In our view the latter will point upwards on deteriorating public finances. We have already stated that the only alternative for propping up the weak Eurozone countries is a collapsing Monetary Union. Germany is not in favour of this. Therefore we think the government finances in the strong countries will come under mounting pressure.

Furthermore, most of the solutions for the Eurozone that are presently on the cards or under discussion – for example the emergency fund – will merely help the weak countries to tackle their liquidity problems. They will do nothing to solve the issue of unequal competitiveness, which would require inflation in the strong countries or deflation in the struggling countries of the euro area. As deflation would merely exacerbate the problems (debts would become a heavier burden), higher inflation rates in the financially robust states could at least be part of the solution. In our view this prospect will push up bond yields in the stronger EMU countries.

Suspicion

Soon enough, the financial markets will realise that a solution to the structural woes of the problem countries will not be forthcoming, at least not to a sufficient degree. As there is no political majority for a comprehensive solution (which would require the strong countries to pour even more money into the ‘black hole’ of the weaker states) the European politicians will likely respond too little, too late. Before long, this could push up bond yields in the problem areas, far more so than in Germany. Therefore the spreads between bond yields in the weaker and the stronger EMU countries seem set to widen.

Rising bond yields – or rather, falling bond prices – in the problem countries will likely aggravate European bank losses as the banks own a lot of bonds that were issued in the weak euro countries.

In addition, European lenders will feel the adverse effects of higher long-term interest rates in the struggling countries which will undermine economic growth. Banks will have to write off more loans as households and businesses are less able to pay off their debts.

Likely, one of the consequences of the new banking problems will be that more banks are at risk from having to close their doors. In other words, there is a higher chance that banks will be forced to default on their debts. The interbank money market – where banks take out or provide loans to each other on a daily basis – will be rife with suspicion. Therefore taking all that into account, on balance, the trendsetting three-month EURIBOR rate could in the coming months rise from around 1% towards 1.5%.

Our in-house research shows that a rise in the three-month EURIBOR rate tends to push up the EUR swap spread (ie the difference between the ten-year swap rate and the yield on ten-year German government bonds). This report will be available shortly to subscribers and trial readers.

Chart 2: Improving business expectations support rising Bund yields
Chart 2: Improving business expectations support rising Bund yields

Source: Reuters EcoWin/ECR

As suspicion rises and uncertainty spreads, credit ratings will likely play a more important part. Germany’s AAA rating surpasses the AA awarded to many swap dealers in Europe. On balance, in the coming months the spread could widen from around 30bp towards 50bp.

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