You've probably heard it many times before, but this time it looks as though it really is "make or break" for the euro. The clue is found in the way the bond market is currently operating. Bond market flows of late suggest that a majority of economic agents are no longer acting on fears of default of the eurozone periphery countries within a durable single currency framework, but effectively positioning for a post-euro environment. In other words, the eurozone government bond market is now behaving as a de facto foreign exchange market. This is a very troubling development, for it implies that large sections of market operators have finally abandoned all hope that eurozone politicians will come up with a credible solution to a crisis that has been left to fester for well over two years. Greece, Portugal and Ireland were never going to bring the euro down; but failure to properly address their situations always meant that the crisis would eventually engulf Spain and Italy. We are now in that situation. The difference is that Spain on its own--not to mention Spain and Italy together--can bring the whole euro edifice crashing down in the blink of an eye.
Once you conclude that the euro is effectively doomed, then there is little choice but to start a comprehensive foreign exchange (FX) hedging strategy. With equity markets pretty much in the doldrums all round, the government bond market becomes the only viable escape route. The government bond market flows that have pushed German, US, UK and Swiss yields to historical lows over the past weeks (e.g. 2y German bond yields are already recording negative levels, while 30y German yields are below those of Japan!) simply indicate that economic agents are working on the very rational assumption that a “Neu Deutschmark”, US Dollar, UK sterling and Swiss Franc will inevitably experience the mother of all appreciations relative to the likes of “New Drachma, Peseta, Lira or Irish Punt” once the euro effectively collapses. And so, the issue of sovereign default is now playing second fiddle to the more pressing issue of allocating all sorts of assets under the protective mantle of the winning currencies, whether in circulation or expected to be, before disaster strikes.
The mix of relentless capital flight and the prospect of an overnight slashing of living standards for the eurozone periphery countries on their return to national currencies is very scary indeed. But there would also be casualties on the side of the “winning” currency countries. Indeed, it is no surprise that governments and central banks in Washington and, above all, London are watching events in the eurozone with undisguised anguish. The UK’s economic policy since the start of the crisis has been fundamentally targeted on keeping the value of sterling down in order to promote export growth. The results of this policy have so far proved underwhelming to say the least. But, in the event of a euro collapse, this "beggar thy eurozone neighbour" strategy would be completely blown out of the water. The Bank of England (BoE) could find itself forced to man the printing presses 24/7, even actively intervening in the FX markets in a bid to arrest sterling's appreciation as the Swiss are already doing. The chances of success of this line of action by the BoE would probably be fairly small, and the cost of trying would be very onerous indeed. Put in simple words: the UK is no Switzerland. It is a bit ironic, but totally understandable, that the broadly “eurosceptic” British government has become one of the main cheerleaders for the euro and is desperate for Germany to save it.
One might think that Germany may be in a better position to deal with a strong currency. After all, they were used to one before the eEuro, weren’t they? And yet, one has to wonder whether the mighty export-led German manufacturing base might want to risk losing the massive competitive advantage the euro has brought them. Even now this is something that would probably prove more costly to Germany than shouldering an effective defence of the eurozone periphery. This means severing the cancerous link between sovereigns and banks. The crisis in Spain is not one of sovereign solvency per se but one of banking solvency undermining the solvency of the sovereign. The German government is naive to think that the Spanish government asking for a "partial bailout" to recapitalise the stricken saving banks (ie. Cajas) will do anything to solve the eurozone debt crisis at this critical juncture. What the markets would do is turn their attention to Italy. In fact, they are already doing so. It wouldn’t take much to find a reason to attack Rome. Signs of government paralysis are already emerging, and with a general election expected in 2013, the political parties supporting the technocratic government of Mario Monti may be unwilling to harm their electoral prospects by supporting too unpopular measures.
Time has finally come for Germany to come off the fence and make an unequivocal choice. The markets seem to have already made theirs. Germany could prove them wrong. But we need an answer in weeks, not months.
