Bloomberg News

Merkel Doesn’t Deserve Sub-Zero Yields as Draghi Plan Gains

August 12, 2012

German Chancellor Angela Merkel

Angela Merkel, Germany's chancellor. Photographer: Jock Fistick/Bloomberg

Stuart Thomson knew what to do last month as Spanish yields rose to records: Sell German bunds.

“There is no way that Germany will not be affected by this,” Thomson, who helps oversee $109 billion as a money manager at Ignis Asset Management in Glasgow, Scotland, said in an Aug. 3 interview. “Spain won’t be able to survive without external help. The bailout will add more burdens on Germany.”

Chancellor Angela Merkel’s softening stance toward European Central Bank President Mario Draghi’s rescue plan for Spain and Italy is repelling investors who bought bunds because of her fiscal vigilance. Investors seeking a haven from tumbling bond markets were willing to accept yields below zero for German bunds due in as long as three years because they were confident in her pledge that she wouldn’t add to the nation’s debt to expand bailout programs for weaker neighbors.

Funds managing more than $4 trillion are turning against bunds on concern Germany’s costs to bail out the euro zone’s most indebted nations will rise. The total may reach 500 billion euros ($614 billion), research firm Graham Fisher & Co. estimates. That amounts to about 45 percent of Germany’s current debt outstanding, according to data compiled by Bloomberg.

“The risk that Germany will have to issue more debt to finance the bailout is real,” said Johannes Jooste, a senior strategist in London at Merrill Lynch Wealth Management, which oversees $1.8 trillion globally and has cut bund holdings since last year. “I’m skeptical of investing in zero-yielding paper. I’m not convinced the current yields are justified.”

Put Options

Ignis and Merrill Lynch Wealth Management are joined by Fidelity Investments, Carmignac Gestion and Pacific Investment Management Co. (PTTRX:US) in reducing or eliminating bund holdings. Banks including BNP Paribas SA, Royal Bank of Scotland Group Plc and Barclays Plc have also sold the bonds.

As recently as July 25 the number of options for the September contract granting the right to sell 10-year bunds exceeded those allowing purchases by the most this year, according to data compiled by Bloomberg. That’s a reversal from May, when calls outpaced puts.

After rising from 1.127 percent on July 23, matching a June 1 record low, the German 10-year yield fell 4 basis points, or 0.04 percentage point, to 1.39 percent last week. The yield on two-year notes dropped below zero percent on June 1, and has been negative each day since July 6, closing at minus 0.074 percent on Aug. 10. Yields below zero mean investors who keep the debt until expiry will receive less than they paid.

Bund Losses

German bonds have lost 0.7 percent, including reinvested interest, since July 25, compared with a 1.2 percent loss for U.S. Treasuries, according to indexes compiled by Bloomberg and the European Federation of Financial Analysts Societies.

At the same time as its bailout burdens threaten to rise, Germany’s gross domestic product growth has slowed for four consecutive quarters, to 1.2 percent from the year-earlier period in the first three months, the Federal Statistics Office said in May. Companies from carmaker Bayerische Motoren Werke AG (BMW) to sporting-goods manufacturer Puma SE said they are suffering as the crisis hurts sales and orders.

Yields on Spain’s 10-year notes rose to a euro-era record of 7.75 percent on July 25 from this year’s low of 4.83 percent on March 1. The difference between Spanish and German 10-year yields reached 6.50 percentage points the same day, also a record, before easing to 5.52 percentage points on Aug. 10.

Crisis Beginnings

Europe’s sovereign-debt crisis started in 2009 after Greece’s newly elected socialist government said the budget deficit was twice as big as previous leadership had disclosed. Since then Greece, Ireland, Portugal, Spain and Cyprus sought external aid.

Spain has already asked for as much as 100 billion euros for its banks and Prime Minister Mariano Rajoy suggested on Aug. 3 he would consider seeking more. Italy’s government also held “lengthy” discussions on a possible request for the bailout fund to buy its bonds as borrowing costs rise, Education Minister Francesco Profumo said on Aug. 9.

European leaders failed at a June 29 summit meeting to agree on issuing bonds backed by all the euro-area members to aid debtors, a plan Merkel had opposed. Draghi then opened the door this month to buying Spanish and Italian securities, along with the euro area’s bailout funds.

Backing Draghi

While Merkel said as recently as July 18 that she won’t take on added liability in the debt crisis without stronger budget oversight, the Chancellor now backs Draghi’s proposals on bond buying to help bring down borrowing costs in Spain and Italy, her deputy spokesman Georg Streiter said in Berlin Aug. 6.

Merkel is also feeling heat from Germany’s main opposition party, the Social Democrats, which suggested last week that the government may need to agree to pay more of the bill to stem the crisis and avert a breakup of the 17-nation currency bloc.

The euro has dropped 6 percent this year, making it the worst performer in Bloomberg Correlation-Weighted Indexes, which track 10 developed-nation currencies. The shared currency traded at $1.2294 and 96.30 yen as of 12:07 p.m. in Tokyo, little changed from the close in New York on Aug. 10.

“I don’t have a lot of confidence about what is going to happen in Germany,” Rose Ouahba, head of fixed-income at Paris- based Carmignac, which manages about $60 billion, said in an interview on July 27. Ouahba sold all her bunds in June and favors Treasuries, where investors have a “clearer” view.

Germany may lose its allure as a refuge from turmoil unless it accepts the cost of achieving closer European integration, said Josh Rosner, a banking analyst at New York-based Graham Fisher. Policy makers should empower the ECB to rescue banks, create a deposit insurance program and allow it to print money, like the Federal Reserve, to support growth, he said.

Germany’s Decision

“As the ultimate costs to Germany become understood, we will see a flight to havens outside of the euro zone,” said Rosner. “The best-case scenario is that Germany’s government finally tells its people ‘Look, there are the costs associated with each of these solutions.’ It’s either full integration or full dissolution.”

Pimco, which runs the more than $260 billion Total Return Fund, the world’s biggest bond fund, said bunds are overvalued and a bubble is forming in the market.

“If you are confined to Europe, then you would prefer to get into more attractive alternatives than bunds,” Myles Bradshaw, executive vice president and money manager at Pimco in London, said in a telephone interview Aug. 9. “Globally there are much better alternatives to bunds. The euro is facing an existential crisis and bund valuations are expensive.”

‘Certain Strengths’

Pimco prefers bonds in “selective” emerging markets and debt from the U.S., U.K., Australia and Scandinavian countries that have “less policy uncertainties,” Bradshaw said.

Demand for German securities will be underpinned by the debt crisis which may drag on for another two years, said Jonathan Lemco, principal and senior sovereign-debt analyst at Vanguard Group Inc.’s taxable research group. Vanguard owns debt of German government-sponsored agencies issued in dollars.

“Germany has certain strengths,” Lemco said in an Aug. 8 interview. “It is a strong well-managed economy. Its fiscal and financial situation remains healthy.”

The nation’s budget deficit will be 0.8 percent of gross domestic product this year, compared with a 3.2 percent shortfall for the euro region, according to International Monetary Fund data. Its current account surplus, a broad measure of trade, is predicted to be 5.2 percent of GDP, compared with the euro-region average of 0.7 percent.

Norway Buying

Norway’s $620 billion sovereign wealth fund, Europe’s biggest, said on Aug. 10 it bought German government bonds in the three months through June, raising its holdings of bunds by 53 percent to 58 billion kroner ($9.8 billion) last quarter.

Some investors are buying on bets that if the euro falls apart, their assets will be redenominated in a relatively safe deutsche mark, said Jamie Stuttard, the head of international bond management for Fidelity Investments in London. Stuttard said his Fidelity Global Bond fund favors German corporate bonds, while it has been underweight the nation’s government securities since November.

An underweight holding is one that’s less than the amount called for by the benchmark index used to measure performance. Fidelity has about $1.6 trillion of assets under management.

BNP Paribas, France’s biggest lender, reduced exposure to German sovereign securities to 1 billion euros as of June 30 from 2.6 billion euros on Dec. 31, according to its second- quarter financial statement.

Open Interest

Royal Bank of Scotland trimmed its bund holdings by 1.7 billion pounds ($2.7 billion) to 12.4 billion pounds during the same period, its financial statement showed. Barclays cut German debt to 1.2 billion pounds from 3.4 billion pounds.

Open interest on put options on July 25 rose to 925,077 contracts compared with 496,823 on call options, according to Bloomberg data. On May 23, the figure for call options exceeded puts by 159,062 contracts, indicating investor demand in hedging against a drop in yields. Open interest is the total number of contracts that have not been closed or exercised.

Recent economic data suggest the debt crisis is starting to hit the economy. German exports dropped 1.5 percent in June after rising 4.2 percent in the prior month, the Federal Statistical Office in Wiesbaden said on Aug. 8.

Germany’s industrial production declined 0.9 percent in the same month. Business confidence, as measured by an Ifo index, fell to 103.3 in July, the lowest in more than two years, it said on July 25.

The euro area economy may shrink by 0.5 percent this year, compared with an average of 1.3 percent growth in the Group of 10 developed nations, surveys of economists by Bloomberg show.

Falling Demand

Falling demand is hurting German companies. Munich-based BMW, the world’s biggest maker of luxury cars, reported on Aug. 1 its first drop in quarterly operating profit in almost three years and said that Europe’s debt crisis could cause “the global economic climate to cloud over further.”

Puma, Europe’s second-largest sporting-goods maker, said last month it will speed up a reorganization after second- quarter profit fell 29 percent and it cut a forecast for net sales growth. Siemens AG (SIE), the region’s largest engineering company, reported new orders fell from a year earlier last month.

Because Germany is the biggest contributor to bailouts for indebted euro partners, the risk is that it will become harder for Merkel to convince voters to loosen their purse strings to help troubled countries in the region.

“Germany is facing a no-win situation.” Brett Wander, chief investment officer for fixed income in San Francisco at Charles Schwab Investment Management Inc., which oversees about $200 billion, said in a telephone interview Aug. 9.

“They could either step up and do a disproportionate amount of work and pay a disproportionate price to keep the system afloat, or if they choose not to, then they will suffer in the long run,” he said. “It’s not fair, but they have no other choice. They all sink or swim together.”

To contact the reporters on this story: Anchalee Worrachate in London at aworrachate@bloomberg.net; Susanne Walker in New York at swalker33@bloomberg.net

To contact the editors responsible for this story: Daniel Tilles at dtilles@bloomberg.net; Dave Liedtka at dliedtka@bloomberg.net


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