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Failed German Bond Auction: An Evil Portent?

Published: April 24, 2010
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Source: Barron's

WHAT IF THEY GAVE a bond auction and nobody came?

That is the ultimate doomsday scenario with the unprecedented fiscal deficits around the world -- that governments' credit lines could run out and they couldn't raise the cash they needed in the bond markets. At that point, after bailing out banks that had faced the same dilemma, who's there to bail out the governments?

That hasn't happened in Greece, ground zero in the European debt crisis. Earlier this week, Greece found ready and willing buyers for its short-term bills, albeit at yields twice what the government had to pay just a few months ago.

It was Germany that didn't receive sufficient bids to sell all the bonds it offered. In other words, the auction failed.

This just doesn't happen in major government bond markets. In the U.S. Treasury market, if the total of bids isn't double the total of securities being offered, it's considered horrific auction.

But, Wednesday, the auction of €3 billion (just over $4 billion) of 30-year German government bonds, or bunds, attracted only €2.752 billion in bids and wound up selling €2.458 billion at a yield of 3.83%.

The Wall Street Journal attributed the shortfall in demand to a combination of the bonds' pricing and heavy supplies of new issues in the European bond markets.

And a spokesman for the German debt agency downplayed the results, saying these things happen ever so often.

But other, more disinterested observers see the failed German bond auction as an expression of the market's concern about the effect of the proposed bailout of Greece on the finances of the core eurozone countries that will have to foot the bill, most notably German taxpayers.

All eurozone bond trading is frozen while the Greek government negotiates the bailout package provided by the European Commission and the International Monetary Fund, says from a keen observer of the global capital markets. So, he wouldn't put too much weight just on the German bund auction flop.

Meantime, Greek government bonds spreads over bunds continued to widen Wednesday, with the yield on the 10-year note hitting 8.25%, up from 8% Tuesday.

But, this market pro continues, Greece will need to be supported with some €10 billion a year from German taxpayers -- about 10% what they had to pay for unification with their brethren in communist East Germany in the 1990s. And the French would have to kick in about half as much, or €5 billion annually. All told, he sees some the rest of the eurozone diverting a total of €100 billion a year to Greece in de facto transfer payments, to the detriment of their economies.

More likely, this observer continues, voters in the rest of the eurozone will revolt and the euro will cease to exist in its present form -- after a lot of good money was wasted to save it. Given that prospect, taking down long German bunds flies against rationality.

Such euroskeptic views have another adherent in Louis Bacon, who heads Moore Capital, a leading macro hedge fund.

In a letter dated April 16 obtained by MarketWatch, Bacon saw the potential of the breakdown of the euro because of the willingness to bail out Greece.

"Instead of punishing the Greeks for their free-rider and fraudulent gaming of the Maastricht rules -- either by ejecting Greece from the Union to propel them to reform and come back at a competitive exchange rate or by forcing them to restructure their debt within the confines of monetary union, either of which would have eventually strengthened and solidified the euro -- the European leaders have decided to reward the prodigal Greeks with a bailout, socializing their ills and taxing once again the prodigious Northern European workers," Bacon wrote.

For investors, the winner recently has been U.S. Treasury bonds. Since a couple of weeks ago, when the prevalent opinion was that yields of Treasuries had no place to go but up -- and by extension, their prices had a one-way ticket South -- the market has staged a stealth recovery. And it's taken place in the facing to a rousing start to first-quarter earnings season for stocks and generally positive economic news.

For instance, the iShares Barclays 20+ Year Treasury Bond fund (TLT), is up 2.7% from its April 7 close. The exchange-traded fund is popular vehicle for investors to take a position in the long end of the Treasury market.

Moreover, while the German government was unsuccessful in attracting enough buyers for its bonds, the U.S. Treasury may be offering significantly fewer securities than forecast.

Royal Bank of Scotland Securities said Wednesday it has lowered its estimates of Treasury issuance by $90 billion through September as the result of an improving budget outlook. The bank cut its estimate for Treasury borrowing in the current fiscal year by $200 billion to %1.3 trillion. And it forecasts a deficit of $1.1 trillion for fiscal 2011, a reduction of $650 billion in borrowing.

Of course, Washington might find itself facing the prospect of bailing out California. Even if that happens, the world might still find the U.S. the best place to stash its cash as it has second thoughts about the euro being a viable rival to the dollar.

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