On Wednesday, some (but not us) were suggesting that the eurozone crisis was now spreading to the core in the wake of the bond auction results. Yesterday came a better reflection of Germany’s place in Europe. France came into line behind Germany, President Sarkozy softening his calls for greater ECB involvement, whilst the German Chancellor retained her opposition to eurobonds.
Instead, she wants to see treaty changes that will accelerate the process of fiscal integration of the eurozone. At the same time, yields on German t-bills were again flirting with negative territory (offered yield), essentially meaning that you have to pay for the privilege of lending short-term to the German government, rather than the other way round. As we’ve said before, this is a reflection of the fact that liquidity, positioning and also sentiment are driving markets right now and that these forces will become ever stronger into year-end. The euro was disappointed yesterday, on the basis that what Merkel is proposing is a longer-term dream and in no way addresses the current solvency issues of several eurozone nations.
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Gilts overtake bunds as Europe’s safe-haven. UK bond yields (10yr) pushed below Germany yesterday, something which last happened briefly in March 2009 and before that for a short time in 2000. There are numerous explanations for the sudden jump in German yields. Some of the very considerable safe-haven demand that propelled Bund yields to record lows recently has obviously been reversed. For some investors and traders, part of the allure of Bunds was very much that they would be more likely to hold their value in the event of a euro break-up and/or if Germany decided to walk away from the euro project. Merkel’s apparent determination to forge ahead with greater fiscal and political union, as made crystal clear in last week’s address to her annual party congress, has partially scuppered some of the markets’ appetite. Arguably, Germany appears to be warming to eurobonds which, if it is committed to greater integration, is an obvious, if not unavoidable step at some stage. The big worry is that this will effectively expose Germany to further significant financial liabilities as a guarantor of the debts of Europe’s many fiscal miscreants. As a result, it is not a complete surprise to see gilts trade below Bunds. The resounding message to Berlin from the bond vigilantes is straightforward: do not underwrite any more of the dodgy debts of the rest of Europe.
UK growth peak. More details on what is sustaining the UK economy were released yesterday. Headline growth remained steady at 0.5% QoQ in Q3, but there was more detail on the drivers. The growth in household expenditure was flat, but after four quarters of decline this could be taken as a positive. The other factor was the strong increase in stock-building after a period in which it had appeared to have normalised. This suggests that some of the weakness seen in overseas markets, and the uncertainty this created domestically, led to an involuntary build-up of inventory. The normalisation of this, together with the continued domestic headwinds of high unemployment and low real income growth, continues to suggest that Q3 will be the peak of growth for several quarters to come.
The changing shape of Chinese policy. Amidst signs that the economy is losing momentum and that inflationary pressures may be easing, Beijing is gradually loosening the policy reins. This week, reserve requirements for some rural cooperative banks were lowered by 50bp. Also, the yuan fell again, to its lowest level for a month in response to the continuing strength of the dollar. Beijing’s preparedness to permit the yuan to weaken is a further indication of its determination to ensure the economy has some protection from the ill-winds blowing in from offshore. Last week, Vice Premier Wang Qishan claimed that “the global economic situation is still grave”, signalling that policy officials recognise the pressing need to begin the process of easing financial conditions. It would be surprising if we did not see further steps to move policy in China in the direction of accommodation over coming months.Get the 5 most predictable currency pairs