Germany Not Immune to Europe’s Contagion

Here is a good article from today's FT ("Germany not immune to Europe’s contagion") that highlights the mounting pressures facing Germany. Although on a standalone basis, Germany should be fine, its banks are highly exposed to contagion risks in Europe's periphery. The article posits that if Spain should default, German yields (which are currently under 3%) could rise sharply higher. Further, German CDS spreads have recently hit new highs (excluding the time period surrounding Lehman's bankruptcy) and the ultra-safe swiss franc has been steadily climbing against the euro. Here are some of the highlights from the article:

The very idea that Germany could be caught up by contagion from the eurozone debt crisis seems risible. Its benchmark interest rates, those for 10-year Bunds, trade below the equivalent levels for the US, UK and France.

Yields of just shy of 3 per cent for 10-year money hardly smack of trouble. Inflation is unlikely to cause problems soon, unlike in the UK and potentially in the US thanks to quantitative easing. It also enjoys a sizeable current account surplus, meaning it is not at the mercy of foreigners for financing, unlike many in Europe. In short, its bonds are still seen as the safe haven of at least the eurozone.

Nonetheless, the whispers are starting against Germany. Yields have risen by more than half a percentage point since their lows in October. Unlike the corresponding rise in US yields, which many see as the result of higher growth expectations, few are touting higher output as a reason for Bunds spiking.

Instead, the markets are firmly putting the blame on the prospect of contagion and in particular the fear that Germany could end up coughing up to bail out most of the so-called periphery of the eurozone.

Pimco, one of the world’s largest bond investors, which by chance is owned by Allianz, the German insurer, has for several months privately been warning that German yields could shoot up once the price of the various European rescue schemes are factored in. Germany’s exposure should remain manageable if the crisis stays restricted to Greece and Ireland (and probably poor Portugal, the next in line for a bail-out).

But the 50-100 basis points question for Germany is what happens to Spain. Should it need a bail-out – and its yields continue to hover close to euro-era highs – then Germany is on the hook for tens of billions of euros more and its yields could well shoot up.