Emu Country Analysis: Germany

A SUPPLEMENT TO EUROMONEY

Germany
CS First Boston

Bunds now on Emu level

This year has been historic for European markets. Fixed income markets expect Emu to start on time because of impressive political will to make it happen even in an adverse economic environment. Lower global bond yields have supported this process, withstanding a temporary setback in the US. Since the beginning of 1996, three-month forward rates after 1999 have fully converged between Germany, France and Benelux. Long bond yields in the core converged in spring, with currencies gaining stability from summer. Spreads between hopefuls like Italy and Spain have also been narrowing sharply through the year.

Support for Emu is growing given convergence trades in the periphery and lower bond yields in Germany. Ten-year Bund yields of 5.7% and Italian bond spreads over Germany of 150 basis points are only a matter of time. There is even a chance to test the 1993 lows in the Bund cash market.

The markets seem to be affected by the political resolve to make Emu happen on time more than by progress on economic convergence. This is reflected in their willingness to forgive the budgetary accounting tricks of various countries, expecting that the stability pact inititated by the Bundesbank will help to deliver long-term fiscal restraint on the Maastricht lines.

Lower US growth and hesitant European recovery

Barring major political upheavals, only two forces could bring the current convergence rush and the downtrend in German yields to an abrupt halt: either a renewed upturn in the global interest rate cycle, or the expectation that the Bundesbank will bring its tightening forward. Both events seem unlikely. Interest rates in the US could go down next year, as recent data point to a weakening of the economy. For most of next year GDP growth may remain below potential, which we estimate at 2.5%, while inflation will be contained by productivity gains and cheap imports. In Germany the strong recovery seen in the middle of this year is likely to give way to a moderate pace of growth at least for the coming six months, before re-accelerating to a 3% annual rate in the second half of next year. The bias towards export and investment growth and the dampening effect of fiscal tightening on private and public consumption (worth almost 1% of GDP next year) mean that consumer price inflation will remain below 2% and certainly not justify an early rate increase. This suggests at least another 12 months of unchanged rates, with a chance of another rate cut to endorse a credible stability pact. With the convergence-related decline in yields across Europe, this will increase pressure on domestic institutional investors to extend duration and could keep ten-year yields below 6%, which is usually seen as a selling level. Although we do not forecast domestic investors to re-assess their immediate yield expectations, we see a good chance of a 5.5% to 6% trading range during the coming 6 months.

Can Emu create new uncertainty for Bunds?

The dollar is contained by moderate growth and interest rates, and its role as a reserve currency is declining. The biggest risk to low interest rates seems to come from political conflicts and rising unemployment in Europe. This could endanger the prospects for fiscal tightening. However, in contrast to the early 1990s, it is now more likely that governments will seek to create jobs via deregulation and labour market liberalization rather than via fiscal measures. This has already been seen in the German fiscal and social reform package (savings package) which sets a framework for a reduction in labour costs and more flexible dismissals.

This would contain inflationary pressure in the long term and make the eventual upturn in bond yields much more gradual than in 1994 or even in early 1996. For the second half of 1997 we expect long yields to remain below 6.5% ­ particularly given the positive background in the US. The Bundesbank may start pre-emptive rate increases in the fourth quarter, but at the end of 1997 we do not expect three month rates to be above 3.75% as currently priced into the market. Further down the road, approaching Emu deadlines ­ the selection process in early 1998 and pending votes by the Bundestag and possibly the constitutional court ­ may spread some uncertainty on the starting date. But this would first lead to an unwinding of convergence trades before having any negative impact on Bunds.

Dr. Michael Clauss

Franco-German convergence