As German Bonds Stagger, UK Could Benefit

The eurozone debt crisis has passed a distressing milestone, with yields demanded by investors for holding German government debt rising above UK rates for the first time in more than two years.

The news suggests UK gilts could replace German Bunds as Europe’s premier safe haven asset for institutional investors. It follows Wednesday’s disastrous bond auction, when the German government failed to sell more than one-third of a planned €6 billion of debt – the country’s worst auction result since the euro’s 1999 launch.

The yield on 10-year Bunds initially rose above gilts on Thursday morning, with German bonds trading as high as 2.23 per cent, compared with only 2.20 percent for gilts. The pattern repeated itself on Friday, with gilt yields below Bund rates for much of European afternoon trading.

Analysts said this about-turn in the global bond market’s usual rules partly reflected the sense that both of Germany’s two possible responses to the eurozone debt crisis – rescuing fiscal danger zones such as Italy or precipitating a breakup in the eurozone by not doing so – would greatly increase her liabilities.

John Higgins of Capital Economics in London said, “This unsavoury dilemma had already led to us to forecast some upward pressure on Bund yields in 2012 and 2013 as the eurozone crisis escalated. However, it now looks as if the pressure is coming to bear earlier than we had envisaged. We doubt it will relent any time soon.” He concluded that “Germany is caught between a rock and a hard place.”

However, the drop in UK yields below German rates also reflects faith in the UK’s fiscal stability.

It seems an unlikely safe haven at first sight: its gaping fiscal deficit is likely to total about 8.5 percent of gross domestic product (GDP) this year, according to the International Monetary Fund. Moreover, economists have progressively slashed growth forecasts in recent months, and the Bank of England – its central bank – has predicted no economic growth until next summer. A eurozone recession – which looks increasingly likely, as the debt crisis hits business and consumer confidence – would prolong this stagnation, since about half of Britain’s exports are to the 17-member bloc.

However, analysts say UK gilts enjoy a key advantage which boosts their security in investors’ eyes. The Bank of England is, unlike the European Central Bank (ECB), authorised to act as the lender of last resort for the UK government – guaranteeing to buy unlimited amounts of debt to shore up confidence, if necessary by printing more money. Crucially, investors also regard as credible the UK coalition government’s ongoing promise of a steady reduction in the deficit, since the administration has already delivered major savings in public spending to meet it.

Risk-averse investors are also turning to UK gilts because of the declining security offered by alternatives, including Germany. David Lloyd, head of institutional portfolio management at M&G Investments in London, says “in the end, the market’s belief in Germany as the safe haven within Europe will erode; it is, after all, a fairly heavily indebted nation that cannot print its own currency.” Gross debt in Germany is more than 80 percent of GDP.

Gilt prices have also been supported by the Bank of England’s decision to maintain its main interest rate at a record low of 0.5 percent – 0.75 percentage points lower than the ECB’s. This pushed yields on gilts to their lowest recorded close last week since 10-year notes were launched in the early 1950s.

In European afternoon trading on Monday, 10-year Bunds were yielding 2.31 percent – a hair’s breadth below equivalent gilts at 2.34 percent. That’s a tiny 3 basis point gap compared with a 44 basis point spread at the beginning of the month, when Bunds were at 2.00 percent and gilts at 2.44 percent.

Ten-year yields on Italian government bonds – whose sharp rise this summer increased the severity of the eurozone debt crisis by several orders of magnitude – were at an extremely high 7.15 percent in Monday afternoon trading, despite a rally in European equities that followed recent heavy falls. Analysts regard 7 percent as marking the point above which yields are at risk of rapidly escalating to the point of default or bailout.