WILLIAM DE VIJLDER Blog - in English

A tipping point?

The disappointing auction of German government bonds this week is open to diverse interpretations.

1. The ‘animal spirits’ theory, which basically entails that investors – for all sorts of inexplicable psychological reasons – had no appetite for buying. That is obviously not much use for an economist.
2. The ‘wake up’ theory. Large investors from outside the eurozone are fed up with the continuing failure to resolve the crisis and want to send a signal by no longer buying German bonds.
3. The panic theory. Investors, both inside and outside the eurozone, fear that the contagion will continue unabated, and that the eurozone recession will be deeper than the mild recession ECB president Mario Draghi recently referred to a. In this case, Germany would get its share of the economic blows, which would push its public deficit higher.
4. The inflation hawk theory. This assumes a ‘deus ex machina’: Germany gives up its resistance to eurobonds or the ECB agrees after all to the unlimited purchasing of bonds. The first scenario could trigger a strong turnaround in economic confidence and suggest that the ECB is fairly quick to decide that its policy is too relaxed. The second scenario could raise fears that unlimited purchasing would ultimately cause inflation. In both cases inflation-averse investors would refuse to buy German bonds at the current yields. I hasten to add, however, that this ‘inflation hawk theory’ has no basis, given recent statements of both Angela Merkel (‘no’ to eurobonds) and Mario Draghi (‘no’ to the ECB as ‘buyer of last resort’).
5. The tipping point theory. Markets have a fine nose for anticipating dramatic events. When the British central bank decided on Wednesday, 16 September 1992, to prop up the pound sterling in the European Exchange Rate Mechanism (ERM) by further raising the base rate by several hundreds of basis points on an annual basis, stock markets rose because investors realised that this desperate measure was doomed to fail. They were right: the pound withdrew from the ERM later that day. Perhaps the reluctance of investors to buy German bonds signals an expectation that a major event is about to happen, that the ‘definitive solution’ is at hand. Judging by recent comments, this seems, at the very least, optimistic; but you could also argue that necessity is not only the mother of invention, but also of compromise and, hence, of a solution.
6. The ‘enough is enough’ theory. This entails that investors are of the opinion that buying long-term German bonds at the current levels is no longer a good idea as the  real coupon rate is negative (inflation is higher than the nominal interest rate).

This last explanation deserves a closer look. After all, until recently, investors were queuing up to buy German paper even though the real interest rate was already negative. Why this change? I see three explanations.

1. Investors no longer believe in a Japan scenario for the eurozone or Germany: there is no danger of deflation and, hence, no prospect of a continuing fall in interest rates.
2. Investors feel they have already invested enough in the ‘safe haven’ offered by German bonds.
3. Investors do not rule out positive developments in the Eurozone crisis in the fairly short term. As an investor, you can respond to this expectation in various ways: aggressively, by buying instruments that have suffered heavily from the crisis (Italian bonds; Eurozone shares); or more cautiously, by buying fewer German bonds and putting the money in short-term deposits. The duration of ten-year German bonds is about 9 years. And as soon as a solution looks imminent, interest rates could easily shoot up by 100 basis points, thus leading to a price loss of 9 per cent. Against this backdrop, the wait-and-see attitude among investors is understandable.

The six different theories are not equally realistic, to put it mildly. If I were forced to choose the least unrealistic one, I would go for the sixth (‘enough is enough’). But even so, it is premature to say that the ‘silver bullet’ solution is near. However, this week’s events suggest that investors believe we are getting closer to a tipping point. Let’s hope that even this modest expectation is not too optimistic.

William De Vijlder
25 November 2011

R-words

Last week was dominated by two R-words: “referendum” and “recession”. The announcement that a referendum would be held in Greece on a yet to be decided question came as a bolt from the blue. Several weeks ago the Bloomberg website had posted a similar report from Greece, but this was denied by Athens the following day. This time it was serious. At least for a few days. The strength of the market response was linked to the introduction of a new kind of uncertainty: would the referendum be about membership of the eurozone, a question which was thought to be taboo until recently? One can imagine the endless media debates between supporters and opponents. It would have been reminiscent of the debates preceding the referendums on the Maastricht Treaty in the 1990s. But these debates were small beer compared to the issue at hand. A second kind of uncertainty was of course what would happen if the Greeks voted “no” on whether to stay in the eurozone. And then there was a third kind of uncertainty, namely whether the Greek precedent would spark calls for referendums in other countries.

So relief all round when the referendum idea was scrapped on Thursday. The key word in this whole saga is “uncertainty”. In this context I recently read an interesting IMF paper entitled “The uncertainty channel of contagion”. The authors show that uncertainty can lead to contagion, regardless of the traditional channels of contagion. These traditional channels include commercial relations (the trade partners of an ailing country become “infected”), or comparable characteristics (countries which are also ailing come under speculative pressure). “Uncertainty” is a completely new channel: surprises on how the situation develops in a particular country raise doubts about the correctness of the analysis for other countries, and these doubts are sufficient to cause contagion in those countries. Or to put it differently: investors do not want to get their fingers burned again and prefer to be safe than sorry, with the upshot lower share and bond prices. The underlying cause: increased uncertainty.

The second R-word is “recession”. There is no uncertainty on this count, at least not according to the ECB president, Mario Draghi, who in a press conference last Thursday spoke of a “mild” recession in the eurozone. Investors should welcome such clarity, if only because it leaves little doubt about the direction of the policy rate: further downwards.

William De Vijlder

8 November 2011