What is interesting is that back in July 2012, as shown in Figure 1, the yield on ten year German debt started to diverge away from its close link with the UK and US ten year yields and move away to look like something closer to the Japanese profile.
Figure 1: Source: FactSet
The effect can be seen more dramatically if you look at the yield curves of those four nations which is shown in Figure 2.
Japan’s y ield curve has been flat for some time. A flat yield curve is thought to indicate weak economic prospects because the market is essentially saying that “we still expect interest rates to be very low in 10, 15 or 20 years time because we don’t expect any economic growth”.
If the yield curve slopes downwards or inverts, then this is generally seen as a harbinger of recession; and a flat curve is getting close to being inverted.
For example, Figure 2 shows that you can lock in yields of about 2% per annum on six year UK and US government debt. That implies an interest rate of about 3% in that sixth year. The equivalent expectation for German rates in that sixth year is closer to just under 1%.
Figure 2: Source: FactSet
So Draghi’s comment in July 2012 started a downward trend in German interest rates. That is clear from Figure 1 and was because the implied cost of German support to the then collapsing PIGS (Portugal, Italy, Greece & Spain) economies was a new rule book which imposed Teutonic discipline on the Southern Euroland nations.
The Germans imposed their “work hard, stop spending and save your cash to pay off your debts” ethic on the Southern Eurolanders. Not spending and saving cash is not everybody’s first lifestyle choice and leads to the somewhat boring life that the Euroland economies now face.
The Germans did not get off that lightly though; they had to agree to a bank bail out fund which, in my mind, laid the resting place of the last buck on the doorsteps of the German Chancellery. Although the Euroland banks cross guarantee each other under the scheme, I could not see Merkel letting a German bank sink under the stress of bailing out one of its Spanish co-signatories.
What we need now is one more deal between the eighteen countries of the protestant North and the Catholic Mediterranean. The Germans need to relax and stimulate their economy whereas the Southern Eurolanders need to walk away from their socialist tendencies and free up their economies.
Eighteen countries need to be corralled and whipped into reform by Draghi. Until then, the flatness of the slope of the yield curve will prevail and the danger that we must watch for, is that our own yield curve does not follow Greater Rhineland closer to the horizontal.