Would Germany subscribe to euro-zone bonds ? The market is hinting at the price of Germany's commitment to Europe. The cost of insuring its debt with credit-default swaps has risen sharply during the past month-and-a-half, to the point where five-year U.K. CDS are now cheaper than equivalent German ones. Although flight-to-safety trades have supported demand for German bonds, the CDS market suggests that might not last long if Germany were to commit to backstopping a common euro-zone bond. There's a further irony in Franco-German demands that all countries in the bloc boost their competitiveness. One of the major imbalances in the single currency is the lack of competitiveness of peripheral countries relative to the core. Unless the core is willing to lose ground here, the region is at an impasse. Saying every country in the euro zone should become more competitive is like saying every child in Lake Wobegon is above-average. A nice idea but it defies the math. Instead, what the Franco-German deal seems to have created is the circumstance under which peripheral countries will be forced out of the single currency. Then again, things were probably heading in that direction anyway.
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Friday, August 19, 2011
Would Germany subscribe to euro-zone bonds ? The market is hinting at the price of Germany's commitment to Europe. The cost of insuring its debt with credit-default swaps has risen sharply during the past month-and-a-half, to the point where five-year U.K. CDS are now cheaper than equivalent German ones. Although flight-to-safety trades have supported demand for German bonds, the CDS market suggests that might not last long if Germany were to commit to backstopping a common euro-zone bond. There's a further irony in Franco-German demands that all countries in the bloc boost their competitiveness. One of the major imbalances in the single currency is the lack of competitiveness of peripheral countries relative to the core. Unless the core is willing to lose ground here, the region is at an impasse. Saying every country in the euro zone should become more competitive is like saying every child in Lake Wobegon is above-average. A nice idea but it defies the math. Instead, what the Franco-German deal seems to have created is the circumstance under which peripheral countries will be forced out of the single currency. Then again, things were probably heading in that direction anyway.
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Usually, the dog wags the tail. Economic fundamentals shape financial market trends. But sometimes, financial panics or manias can be so pronounced that they distort the underlying fundamentals. For a while, the tail wags the dog. In the wake of some policy blunders, we have entered such a phase of panic.
It is the nature of panics and manias that they drive asset prices away from fundamental valuations. For a while, such exaggerations reinforce themselves as investors are inclined to pay more attention to facts, events or mere rumours that seem to justify their current concerns than to longer-run fundamentals.
Fortunately, panics do not last forever. Ultimately, reason prevails over fear and markets price long-run trends more accurately again. In retrospect, such phases of panic are eventually revealed as great opportunities. But before we get back to sanity in markets, the next few months could be exceptionally rocky.
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