German capital markets look to the future

A EUROMONEY SURVEY - MARCH 1996

Beyond the shadow of EMU

"If you look at German newspapers," says Tim von Halle, managing director of fixed-income sales and trading at West Merchant Bank (the investment banking arm of Westdeutsche Landesbank), "it is clear that at least 60% of Germans don't believe European economic and monetary union (EMU) will happen by 1999."

Analysts and investors increasingly appear to agree, galvanized by German finance minister Theo Waigel's recent admission that even Germany is behind schedule in meeting the Maastricht currency-convergence criteria. The admission prompted one German banker to remark - only half in jest - that aside from Luxembourg, the economies best equipped to meet the criteria by 1999 are Argentina and New Zealand.

Several banks are beginning to discount a delay in currency convergence. For example, Banque Paribas Capital Markets reported in January "we believe that some degree of flexibility is desirable in applying the Maastricht criteria but it currently looks as though a good deal more than mere flexibility is needed to get EMU off the ground by the target date of 1999. Our view is therefore that EMU is most likely to be delayed because 1999 is simply unrealistic as a starting date, unless the financial underpinnings of EMU are to be discarded or a political deal between France and Germany overrides the Maastricht criteria."

Neither of these eventualities seems probable: flexibility is unlikely to appeal to a Bundesbank already sceptical of the long-term soundness of the proposed new currency, the Euro, while a behind-closed-doors "deal" between France and Germany on, perhaps, a mini-Euro, is unlikely to endear either country to those EU governments which have battled to implement austere and domestically unpopular convergence plans.

Whether players in the German bond market were already factoring in the possibility of EMU delay last year is open to debate. Through the year, the steepening of Germany's yield curve, in which the spread between two-year and 10-year Bunds climbed from 112 basis points (bp) to around 270bp by the end of December, was attributed to worries about the long-term security of the Euro. "What we saw last year," says Mary Bloem, European bond analyst at Banque Paribas in London, "was a substantial flow of German assets into short-dated German paper and into Switzerland because of [investor] concerns that if they were long-term holders of German Bunds they would be paid in Euros."

Bloem points to several other factors militating last year against concentration at the longer end of the curve - above all, the short-term prospects for further Bundesbank easing of interest rates and the scope for continued Deutschmark strength.

At Merrill Lynch in Frankfurt, vice-president Manfred Ludwig believes, however, that investors are already dismissing the possibility of convergence by 1999. "The story last year was a risk premium at the long end of the curve and demand concentrated in maturities up to five years," he says. "Now that seems to be receding. A lot of investors were of short duration and now we're seeing many of them move along the yield curve."

The proof, according to many Frankfurt syndicate managers, was in the demand - local and international - for Deutschmark issues stretching along the curve. Although this has been dampened somewhat by the recent fall-off. While sovereigns such as Sweden and Finland issued at five and seven years respectively, Austria opted for a 10-year maturity - an important breakthrough, given that it was the first good-sized 10-year Deutschmark issue since July.

Demand for the issue (especially from east Asian accounts), encouraged the deal's lead manager, Dresdner Bank, to increase it to Dm2 billion from Dm1.5 billion. Austria, which reportedly was keen to test an even longer maturity of 12 years, was then followed into the 10-year sector by a cluster of other borrowers, including domestics such as L-Bank (a Dm1 billion global issue) and Landesbank Hessen-Thüringen (Helaba). However, the recent market downturn has restrained issuance since late February.

Underlying demand for longer-dated paper is not just a reflection of diminishing concerns about the Euro, or of over-supply of five-year paper. At DG Bank in Frankfurt, fixed-income director Willi Ufer suggests that many domestic investors, shell-shocked after 1994's upheavals, missed out on much of last year's rally and are now becoming increasingly edgy about their performance records. "The long end of the curve is falling as domestic investors become worried about their performance requirements," he says. "They are beginning to realize that every day they stay in the money markets they're losing money." Much the same argument could be made for emerging-market Deutschmark issues, which have flooded the market in early 1996. Frankfurt-based bankers point out that strong demand for Latin American issues, in particular, has been driven by yield-hungry German and Swiss retail accounts rather than by domestic insurance companies.

Booming investor demand for an expanding range of maturities and credit risks is one reason why bond market professionals in Frankfurt are in euphoric mood. They appear almost uniform in their belief that all fundamental indicators point towards an extension of the bull market in German bonds (once the market rebounds), through at least the first half of 1996. With German unemployment pushing past the four-million mark, and with Deutsche Bank, for one, putting the chances of a German recession in 1996 at 30%, analysts appear to agree that concerns about inflation (for once) are taking a back seat to fears about joblessness. This leaves the way open for further interest-rate easing [as yet initiated] by the Bundesbank.

As recent research published by Deutsche Morgan Grenfell notes: "Economic growth has recently come to a standstill, so that the Bundesbank's latest rate cut (in mid-December) now looks more than justified. With the discount rate at 3%, there is for the moment plenty of room to let money-market rates fall further. Should the economy worsen sharply, however, we would expect the discount rate to be cut to the historical low of 2.5%." For those contemplating the short-term outlook for German bonds, the Deutsche report adds: "We do not expect a definitive turnaround in monetary policy - an increase in interest rates - until the first quarter of 1997 at the earliest."
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