Germany Going Down with the Ship

11/16/2011 10:49 am EST

Focus: MARKETS

Igor Greenwald

Chief Investment Strategist, MLP Profits

Not even the rout in the bonds of its closest allies could convince Germany to alter its disastrous course, writes MoneyShow.com senior editor Igor Greenwald.

Can the markets persuade Germany it’s wrong before Germany wrecks Europe and the global economy? It’s been an exciting race, but right now the German death wish is pulling away in the stretch.

On Friday, the markets cheered the new governments (if not exactly new faces) taking charge of Italy and Greece. Now that optimism is ancient history.

Tuesday came news that European GDP expanded just 0.2% quarter-over-quarter this summer. Germany and France did a bit better than that, but Spain stalled, the Netherlands shrank, and Portugal edged closer to Greece among the no-hopers.

Meanwhile, the European Central Bank revealed that it did pretty much fiddle while Rome burned last week, its purchases of  sovereign (mostly Italian and Spanish) bonds totaling just half of what they’d been the week before.

The $6.2 billion the ECB spent was dwarfed on Tuesday by the heavy institutional selling of sovereign European debt—and not just Italian and Spanish bonds but, more worrisomely still, those of France, Austria, and the Netherlands, all rated AAA but trading like the credit agencies are once again hopelessly behind the curve.

France’s ten-year yield is now up to 3.67%, from 2.57% on October 3; the spread between the French and German yields has doubled to nearly 2% in the last three weeks. The cost of credit-default swaps on French bonds has now topped that for junk-rated Indonesia; in the same market, Italy has been seen for months as a bigger risk than Egypt.

How bad was Tuesday in the bond market? Bad enough, writes SwissInvest Strategist Anthony Peters, that if it had happened to stocks, “every newspaper in the world would be headlining with ‘Meltdown!’ accompanied by pictures of chaps sitting in front of screens with their heads in their hands and telephone numbers of figures as to how much value had been wiped…”

European yields have been erratic Wednesday, propped up by more buying by the ECB, but pressured by the growing realization that there are few other obvious buyers in the current circumstances.

Meanwhile, the European banking system threatens to grind to a halt, amid capital flight out of banks on the periphery. Italian banks have turned into de facto wards of the ECB, dependent on loans from the central bank to meet their obligations.

The ECB’s see-no-evil rules for the collateral it currently accepts are no longer lenient enough for Italy’s UniCredit, which is asking for them to be loosened further.

And what’s Germany’s response to the shrill of all these alarms?

“The way we see the treaties, the ECB doesn’t have the possibility of solving these problems," Chancellor Angela Merkel said today. So, no soup for you, Europe, and no printing euros to buy sovereign debt, though the ECB will supply them liberally in exchange for much dodgier collateral from banks.

This ensures that the ultimate cost to the German taxpayer will be orders of magnitude greater when all those banks on the periphery can’t pay the ECB back.

It would be a lot cheaper if, as an Economist correspondent suggests, the ECB would simply guarantee a certain maximum level for Italian and Spanish yields from a given future date, in exchange for certain policies today. It would be better, of course, if those policies promoted growth as well as reforms, rather than deflationary austerity.

But in either case, chances are the yields would fall right away, as long as the markets found the commitment credible.

That’s a big if, of course, and would require Germany not only to endorse the policy but to co-sign it in blood just to prove it’s really ditched all of its reservations.

That could happen, only because the alternatives are so hideous. But it might not happen in time to matter.

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