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Decimal Digest
18 Jun 2012

Bond Market: lemmings off the cliff?

In the last few weeks the German bond market, especially at the short end, has rallied wildly with yields moving to near zero levels.

In the past, we have stated in this weekly, that Germany may be one of the biggest losers in the current Eurozone crisis due to its large banking exposure to problem nations and the growing TARGET2 balances of the Bundesbank.

The market seem to be ignoring these issues and the huge inflows into Germany are baffling to say the least, giving us a déjà vu of subprimes and peripheral bonds trading in 2006-2007.

Central banks, managing badly designed settlement system, are one of the few institutions who can acquire assets without any ab-initio intention to acquire them. If one looks at TARGET2 assets of Bundsbank, they are unintentionally acquired foreign assets of a central bank.

Quality of assets matters, in the long-run, for every organization. For central banks, quality of their foreign assets are more important, because any loss on these foreign assets will ultimately result in transfer of wealth from residents to foreigners. A loss on a domestic asset held by a central bank is a mere transfer between two classes of residents (taxpayers and sellers of assets), which is a net zero-loss for the nation as a whole.

With this preamble, we compare Germany’s debt burden on future generations with other large economies in the table below:

Table 1: Debt burden on future generations:

Source: Decimal Point Analytics

In the above table, net debt is defined as gross general government debt minus cash equivalents of government entities. National debt held by central banks is shown as a negative item, because effectively, this debt is not payable to a non-government entity, and hence it is not a real burden on future generation of that nation, although it has an effect on inflationary expectations. “Other Items” are essentially low-quality foreign assets owned by the central bank. Here, Germany is the only nation to own such an asset through the TARGET2 system. This item has a very high chance of becoming a burden on future generations.

When we look at things in this perspective, German debt looks worse than that of the USA and the UK; and if TARGET2 liabilities keep on zooming at the same pace they have in the last two years, Germany will be in the same position as Japan in less than one year.

Does it mean that all the hard work of German Mittelstand will get washed out due to the badly designed fund settlement system? However fervently we wish that it does not happen, we are not sure that Germany will come out unscathed in this crisis. In the meanwhile, are the bond markets again behaving like lemmings jumping off cliffs; though some smart money seems to be thinking through the end game – German CDS have jumped nearly 50% over the last two weeks. Truly, there is no real risk-free asset right now, if one chooses to see gold as a barbarous relic as stated by JM Keynes.


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