Euro Break-Up Beckons

It’s a holiday here in the US so we can all sit back and watch the slow motion dance towards the break-up of the Euro while we ponder our own ineptitude. An ineptitude that, fortunately, we can take a day’s break from.

Why talk of the end of the Euro?

Because of the spectacle that unfolded in Germany this week. A regular small sale of German bonds was significantly undersubscribed. Only two thirds of the offering was taken up, meaning that the German central bank had to buy the rest for secondary sales over the next few days.

The shock of this should not be underestimated, although the immediate reaction from the serious folk in various German official institutions was to minimize it. Think this through: the German government was unable to attract sufficient investor interest to sell all of the bonds it wanted to. The Euro mess has arrived at a point where investors are unwilling to buy any bond denominated in Euros. Not even those issued by the rock solid heart and soul of the Eurozone.

Something is seriously amiss.

What appears to be happening is that the credit markets have tired of the incompetence and timidity on daily display by Euro governments, and the total and abject denial of responsibility on behalf of the European Central Bank. So they have developed a working hypothesis: the Euro will break up. With no one willing or capable of defending it, and with the Germans in particular steadfastly refusing to act decisively, the markets have concluded that this episode ends only in one way. And since that ending would usher in monetary chaos, a cascade of bank failures, plus an immediate contagion across the entire continent, the only sensible investment strategy is to run for the hills. Abandoning Germany along the way.

We have spoken glibly of peripheral economies throughout this crisis. That is to create a differentiation between the problem children and the erstwhile more secure economies at the core of the Euro project. Germany is the core of the core. That suspicion and fear has crept into German bond auctions is the clearest possible sign that the credit markets just don’t believe anyone has the nerve or strength to resolve the crisis.

We were told that one possibility for the rotten auction was the very low rates on German bonds. That’s possible. But I think it is more that those low rates do not suitably price in the default risk implied in the Euro zone in general rather than in the German economy specifically. In other words investors are overlooking or ignoring the supposed safety of the German economy and pricing in an element of risk not present locally but which pervades the Euro zone generally. The German banks, for instance, are highly exposed to sovereign Euro risks, and are thus not immune to failure. They may not be as bad as the French banks, but they are not clean either. Hence the rising risk and, in the face of very low rates, a decision that German bonds are not priced to factor in that generalized risk.

Look at it this way: German bond rates are now higher – marginally – than UK bond rates despite the fact that the UK economy is in far worse shape than the German. Worse still for those concerned about the future of the peripheral Euro nations is thee implied inflation rate embedded in German interest rates. It is now down to about 1%, perilously close to deflation in Germany and indicating dire deflationary prospects for those economies that need to re-establish competitiveness with Germany in order to recover.

If, at the outset of the crisis, we had presented a worst possible case for how it would unfold, this is it.

Even the Germans have been sucked in.

Now what do they do?

Enjoy the holiday everyone. We have our own crisis to attend to tomorrow.