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Foreign Exchange

UK borrowing costs fall below Germany’s

The UK has become Europe’s safe haven of choice, judging by action in the bond market, with the yield on benchmark 10-year gilts moving to stand lower than those on German bunds.

Such a state of affairs is rare: it happened briefly in March 2009 and for a short period in 2000. Indeed, the average spread of gilt yields over bund yields during the past 20 years has been about 80 basis points. The development followed the surprise failure of a German 10-year auction on Wednesday, which sent the euro sharply lower against the dollar and knocked confidence that Berlin could underwrite the euro project.

On Thursday, yields on 10-year bunds rose 33bp to 2.23%, while yields on 10-year gilts ticked up 6bp to 2.2%.

Simon Derrick, head of currency research at Bank of New York Mellon, said Germany was going to be appalled by the result of Wednesday’s auction and the resultant rise in bund yields.

“Germany has always been extremely protective of its domestic market,” he says. “It is the rate of change that is so alarming.”

That said, Derrick believed that for currency markets, it was not such a crucial development that gilt yields had moved lower than those on bunds, as witnessed by the relatively small downside move in EURGBP in the past two days.

Indeed, some argued that the rise in bund yields might, in the end, be positive for the euro as it pushed German policymakers to get a firmer grip on the eurozone debt crisis and finally get ahead of the market.

However, Michael Derks, chief strategist at FxPro, said the rise in bund yields was a reflection of fears that Germany was going to become further embroiled in bailing out the eurozone, given that part of the allure of German paper had been that they would more likely hold their value in the event of a break-up of the euro.

Those worries have been sparked by German chancellor Angela Merkel’s apparent determination to forge ahead with greater fiscal and political union within the eurozone, and signs that Germany was softening its opposition to the issuance of eurozone bonds.

“If the euro survives, then Eurobonds are probably inevitable, although the big worry is that this will effectively expose Germany to further financial liabilities as a guarantor of the debts of Europe’s many fiscal miscreants,” says Derks.

“As a result, it is not a surprise to see gilts trade below bunds. The resounding message to Berlin from the bond vigilantes is as follows: do not underwrite any more dodgy debts for the rest of Europe.”

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