The haven status that drove German yields to record lows is fading as the fourth bailout of a euro member stokes investor concern that the currency bloc’s biggest economy will be left picking up a mounting tab.
“If the euro region continues, then there must come a time when there is a fiscal union and burden-sharing, and that would make the market think more deeply about the creditworthiness of Germany,” said Ralf Ahrens, who helps manage about $20 billion as head of fixed income at Frankfurt Trust.
The discount Germany enjoys relative to the U.S. for 10- year borrowing has narrowed to the least in more than three months after Spain asked for a 100 billion-euro ($125 billion) lifeline for its banks on June 9. Traders of credit-default swaps also are buying protection against the risk of losses on German bonds, with the costs of insuring the nation’s debt surging to the most since January compared with similar contracts on U.S. debt.
Greece holds an election in three days that may lead to it becoming the first nation to exit the 17-nation currency union. German Chancellor Angela Merkel has resisted calls to ease Europe’s debt crisis by allowing joint bond sales, telling German lawmakers yesterday that wider burden sharing and ceding budgetary control “go hand in hand.”
“There is a greater awareness now that the outcome of this crisis could well be quite painful for the German economy,” said Ciaran O’Hagan, a strategist at Societe Generale SA in Paris. “The contingent liability on Germany is rising. The losses we have seen have to be paid for by somebody and there is a sentiment that taxpayers in the rest of Europe are not going escape unscathed.”
Ten-year German yields have risen 17 basis points this week to 1.50 percent as of 8:38 a.m. London time, up from a June 1 record low of 1.127. The yield gap to Treasuries narrowed to 11 basis points yesterday, the least since Feb. 28. The gap between 10-year bunds and U.K. government bonds has narrowed to 26 basis points, also the least since February and compared with an average 49 over the past five years.
“We don’t want to have too much German interest-rate risk,” said Andrew Balls, head of European portfolio management at Pacific Investment Management Co. in London, which oversees the world’s biggest bond fund. “There is a big flight to quality premium embedded in German bonds. In the event that the euro zone gets better, these premiums will be unwound and German yields will have to rise. If the situation gets much worse, the money may leave the region all together. We favor cleaner dirty shirts, like gilts and Treasuries.”
German 10-year yields have averaged 3.17 percent during the past five years, more than half the current level. The two-year rate is 0.12 percent, compared with 0.29 percent in Finland and 0.37 percent in the Netherlands, the euro-region countries with the second- and third-lowest borrowing costs
“The German balance sheet remains relatively strong, so it’s not certain that these fears about Germany paying will translate into meaningful moves in the bund price,” said Nick Eisinger, a sovereign analyst in London at Fidelity Investments, a U.S. mutual fund company with $1.6 trillion of assets. “In the short run, yields could still fall.”
Recessions and rising borrowing costs for Europe’s most indebted nations are opening divisions among government leaders as investors question their ability to hold the euro together. Germany is the biggest contributor to the euro-region bailouts for Greece, Portugal and Ireland, with commitments to the European Financial Stability Facility worth about 211 billion euros, or 27 percent of the total.
Merkel’s government favors an austerity-led response to the debt crisis, limiting the liabilities of German taxpayers. “Simply borrowing” isn’t the answer to solving the crisis, Merkel said in a June 12 speech in Berlin.
The difference, or spread, between the costs of insuring against default in German and U.S. sovereign debt jumped to 60 basis points on June 12, from this year’s low of 35 on March 19. The contracts on Germany reached 110 basis points this week, the highest since Jan. 9, based on closing prices, showing increasing demand for protection against increasing German obligations.
“The market is realizing that Germany isn’t a one-way bet at recent yield levels,” said Roger Francis, an analyst at Mizuho International Plc in London. “If a crisis is avoided, it will probably only be because Germany agrees to stump up in one form or another, either in direct cash aid, shared liabilities or domestic fiscal expansion. If we do have a Greek exit, then Germany will be faced with recapitalizing the ECB, and at risk from financial chaos and an economic slump in the euro zone.”
Europe’s turmoil is weighing on growth. The euro-region economy will contract 0.4 percent this year, according to economists’ forecasts compiled by Bloomberg. That compares with growth of 2.2 percent in the U.S. and 0.2 percent in the U.K.
German bonds handed investors a loss of 2.1 percent this month, trimming their year-to-date gain to 2.5 percent, according to indexes compiled by Bloomberg and the European Federation of Financial Analysts Societies. U.S. Treasuries have gained 1.9 percent since the start of the year and gilts have returned 1.4 percent, the indexes show.
“Investors are beginning to factor in the potential damage to Germany if this constant chip, chip goes on,” said Bill Blain, co-head of the special situations group at Newedge Group Ltd. in London. “If there is fiscal union, Germany pays. If there is banking union, Germany pays. It isn’t a pure safe haven anymore. Being the last man standing won’t be a good thing.”
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