Germany -- You're Next

 | Nov 09, 2011 | 12:00 PM EST  | Comments
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As I write, the Italian sovereign bond yields have increased and flattened, with the 2-year to 10-year spread close to zero and both yielding above the absolute default level of 7%.

The financial media is drawn like moths to a flame into discussions of contagion into the other debtor sovereigns in Europe: Spain, Ireland, Portugal. And that focus is fine for institutional speculators and traders at this point. Retail traders and investors, though, should avoid trying to game such issues, and rather look at the longer-term prospects for what is unfolding now.

Investors should be focused on Germany.

As I've written in the past, Germany is trying to hold the European Union members and the union itself to fiscal and monetary rules as mandated under the Maastricht Treaty that are not only not workable, but are now killing the union's private economies, including Germany.

The principal fiscal rule is the stability and growth pact (SGP), which is supposed to limit union members to gross sovereign debt to GDP of no more than 60% and annual sovereign budget deficits of no more than 3% of GDP.

The principal monetary rule is the inflation-targeting mandate of the ECB, which is supposed to preclude monetary stimulus when EU inflation is above 2%. For the past 20 years, since the euro was introduced, the ECB has adjusted how it measures inflation, changed the 2% inflation rate from a ceiling to a target, and extended the length of time to achieve the target.

This has all been done to try to justify monetary intervention while claiming to still be operating within the inflation-targeting mandate and thus not violating the treaty.

Germany has acquiesced to such maneuvering throughout the process. More important, however -- and the subject of this column -- is that all members including Germany have been in violation of the stability and growth pact since the euro was introduced.

The immediate economic repercussions of the events unfolding in Europe are now known. The trajectory for economic activity throughout the next year at least is negative. German economic activity will decrease dramatically as its primary export partners -- the rest of the union members -- all go into recession simultaneously.

The increased sovereign yields throughout the union, except Germany, will preclude the other member states from fiscal stimulus, rendering the stability and growth pact meaningless. Germany, however, will have both the opportunity and necessity to stimulate through fiscal stimulus, borrowing by issuing new sovereign debt -- and violating the SGP to an even greater extent. The opportunity is made available by the plunging cost of capital to Germany as capital throughout the union has flowed into German bunds on a flight to safety, sending its yields to the lowest of all industrialized countries, excepting Japan.

Japan, however, has a sovereign central bank that can monetize the issuance of new debt and stave off the natural corresponding rise in yields the private markets would otherwise require. Germany does not have that luxury.

As German economic activity declines precipitously over the next 12 months, the German government will issue new debt to offset the contraction in private sector activity. In the process, it will also be competing against German companies issuing debt for the same reasons, putting upward pressure on the cost of capital to the private sector.

As this process plays out, volatility throughout the European capital markets will increase on expectations of contagion on the one hand and Maastricht Treaty changes on the other. The increasing volatility will overcome investors' ability to measure risk and send capital fleeing the union in search of a safe haven. A safe haven in this situation is a large country with an independent but sovereign central bank -- the U.S.

The immediate impact will be for capital to park in U.S. Treasuries, sending yields on long-term Treasuries to record lows; 2% on the 30-year and 1% on the 10-year is reasonable.

The real damage, however, will be longer-term and global. As China's exports to the EU plunge, economic activity in China will decrease, causing the Chinese government to have to stimulate ... exacerbating the nascent price inflation there.

The resulting increase in concerns by private capital all over the world -- over economic activity, civil unrest, political and governmental activism in China, and seizure of such in Europe -- will cause short-term flights to safety to metastasize into long-term structural capital flight to the U.S. by global corporations seeking political stability.

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