The euro project stands at a crossroads, with German 10-year bond yields rising to stand above those of the UK, Switzerland, Denmark, Sweden, Japan and the US last month.
"The bond markets appear to be of the view that the euro’s salvation lies in Germany’s capitulation and endorsement of a fiscal union – the only alternative to which is the European Central Bank becoming a fully fledged lender of last resort," says Neil Mellor, G10 FX strategist at Bank of New York Mellon.
What has been noticeable during the sharp sell-off in eurozone sovereign bond markets has been the relative resilience of the euro, given the heightened speculation over a break-up of the single currency.
The euro is trading only marginally below its 12-month average against the dollar, and remains some 20% above the level when notes and coins came into circulation almost a decade ago.
Some analysts put the euro’s resilience down to deleveraging by eurozone banks, which are pulling money home to meet funding requirements. Others point to demand from Asian central banks, with some speculating that China has been active in propping up its trading partner.
| Steady amidst the turmoil |
| The euro against the dollar since inception |
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| Source: Bloomberg |
Thorny problem There is, of course, also the thorny problem of what to sell the single currency against.
The dollar and the pound are weighed down by central banks committed to keep monetary policy ultra loose for the foreseeable future, while the yen and the Swiss franc have been taken out of the game by central banks committed to intervene in the market to quash strength in their currencies.
Positioning also seems to have played a part in explaining the euro’s robust performance, with data from banks showing that bets against the single currency are close to record levels.
Kit Juckes, Société Générale’s head of foreign exchange, says that, unlike sovereign bond markets, which are reliant on a constant inflow of money as governments finance their deficits, the euro only falls if there are active sellers of the single currency. "The market is short and bearish," he adds.
Market participants are now preparing for the ejection of Greece from the single currency – an event that the country’s central bank says has the potential to "set Greece’s economy, standard of living, society and international standing back many decades".
Banks have also been preparing for such an outcome, with one source at a UK clearer telling Euromoney that the bank has been testing its systems for the sudden reintroduction of the drachma – thought to be the most likely scenario for a Greek exit from the eurozone.
Non-eurozone central banks, most notably the Bank of England, have been openly talking about a break-up, while other interested parties have also been making contingency plans.
Icap, the world’s largest electronic foreign exchange broker, has been "knocking the dust" off pre-euro currencies to make sure everything works, while Reuters says it can easily add or remove currencies from its trading platforms.
The floodgates for the latest deterioration in sentiment were opened in September when German chancellor Angela Merkel said it had been a political mistake to let Greece into the euro in the first place.
The genie truly came out of the bottle after Merkel broached what had seemed to be a taboo subject: that it was possible that Greece might have to leave the currency union.
If Greek membership was up for debate, then who else could follow Athens out the door?
Indeed, investors have systematically attacked eurozone sovereign debt markets as policymakers have wrangled over the structure of the support mechanisms needed to get on top of the crisis.
The latter, wrongly believing they had time to get to grips with the contagion spreading across the region, have consistently been behind the curve, with the ECB’s reluctance to become a lender of last resort to indebted eurozone states and Germany’s hesitance to become the region’s banker cutting a swathe through European bond markets.
The sheer speed with which eurozone bond markets were deteriorating was evident as the market, in the space of a less than a week, went from focusing on the unsustainability of Italian debt to digesting news of the weakest demand at an auction of 10-year German bonds since the euro was created.
That the contagion spread so quickly to Germany was a shock, not least to policymakers in Berlin, which clearly holds the key to what happens next.
Its success – or lack of its own crisis – means that the price it has to pay to keep the eurozone together, and protect its main export markets, is higher borrowing costs.
Choice
Germany has a choice: it either chooses to lead the eurozone out of the current crisis, or manages the break-up of the single currency.
The dollar is weighed down by a central bank committed to keep monetary policy easy for the foreseeable future and an impasse on Capitol Hill that makes any attempt to rein in the US government’s massive fiscal deficit unlikely.
In the UK, the government is committed to aggressive action to improve the country’s dire fiscal position, but the Bank of England has made it clear that it is equally prepared to keep monetary conditions ultra loose. The European Central Bank, for all its failure to get a grip on the crisis, has not after all resorted to the printing press yet.
