Germany’s approval of a bailout package for Spain’s banking sector did not stop Spain’s borrowing costs from rising to record highs on Friday amid growing doubts that the country can escape a full-blown bailout. At the same time, German bond yields continue hitting all-time lows.
In June this year, yields on the two-year German note had turned negative for the first time. Last Friday saw the one-, two- and three-year bonds sink further into negative territory.
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A negative yield means that, once inflation is factored in, investors agree to receive back less than they lend. The only valid reason to do this is to avoid an even bigger loss. Hence, investors believe German bonds to be less risky than the money they pay with.
In effect, the market seems to be pricing in the increasing probability of a break-up of the euro area: If bonds acquired in euros were to be redenominated in a new German currency, an investor would not lose, but may even gain in value.
Yet the question who will have to foot the bill if bailed-out countries don’t pay their money back remains unsolved. One can easily imagine that if the euro zone falls apart, Germany ends up as the major guarantor of European debt. Last year, the German edition of the Financial Times sketched the possible outcome of a “euro apocalypse“ for the country. According to the newspaper, it could prove a “depression of historical dimensions“.
Says David Milleker , chief economist at Union Investment, “The end of the euro would lead to a wave of bankruptcies of states, banks, firms and private households. Germany would lose major export markets from one minute to the next.“ An exceeding flight of capital to Germany and a consequent appreciation of the Deutschmark of up to 50 percent would further decimate German exports.
The financial system in Europe could be hit just as hard. External claims would partly have to be converted into weaker currencies, causing immense bank write-offs. The banking sector might collapse: German assets would be destroyed, tax payers would have to bail out the failing banks.
With this scenario in mind, Germany, rather than being a safe haven, looks more like the eye of the storm.