German Debt Drama

Story Highlights:

• A recent German government bond auction failure has some worrying large fiscal projects will be more costly and difficult to fund than widely thought.
• Seven such auctions failed last year. However, last week's German shortfall is the largest in roughly eight years.
• Countries with fundraising difficulties can change an issue's terms, look to non-commercial revenue sources, print money, or raise taxes.
• The German failure could show somewhat waning risk aversion, as some investors may be choosing higher-yielding corporate bonds over low-yielding government securities.

________________________________________________________________________

US markets were down Friday after the government announced unemployment rose to 7.2%. Though widely expected, perhaps that's what stocks responded to. Or as has often been the case lately, it may have been daily randomness with high volatility—nothing new given the last several months. In either case, we discuss why worsening unemployment shouldn't drive today's investment decisions in Friday's cover story.

But the world isn't one country, and we've noticed another piece of global news that's gone mostly unnoticed in the US. A recent German government bond auction failure has some worrying large fiscal projects will be more costly and difficult to fund than widely thought. We imagine this could contribute to global market jitters.

It should be noted a bond offering failure doesn't mean no funds were raised; rather, failure is when not all the money asked for was provided. Other recent Eurozone offerings have failed also—in the Netherlands for instance—but none with the stature and perceived safety of the German government. But even then, this isn't the first time a German auction has failed. Seven such auctions failed last year. However, with only 87% of the €6 billion up for auction purchased, it's the largest shortfall in roughly eight years.*

So a bond offering failure isn't a good sign, but it's also not unprecedented nor does it mean funding will suddenly dry up going forward.

It's plausible there's currently a disconnect between issuer and investors—the offered interest rate could be too low or the duration too long. After all, at some point, yields will simply be too small no matter how much safety they may seem to offer. But to play devil's advocate for a moment, let's say bond markets dry up, even for the big boys like Germany. There are still fundraising options. Changing the terms (raising yields or shortening duration), looking to non-commercial revenue sources like the IMF, World Bank, or other governments, printing money, raising taxes, and so on could all be done. These are governments after all—they make the rules.

It remains to be seen whether bond auction failures will pose a larger problem down the road. The US government has yet to experience similar travails—recently completing a $30 billion auction of three-year notes with 2.21 times more bids than the amount offered.

We've noted several times in this space there is plenty of cash sitting on the sidelines. One way or another, that cash will eventually seek a home. In that light, a German offering failure could mean credit market risk aversion is waning somewhat. Crazy? Hardly. Alongside the government fundraising failure, nine German corporations sold a total of €3.8 billion of long-term debt at more appealing yields. Emerging markets (like Brazil, Colombia, the Philippines, and Turkey) recently completed successful bond sales at attractive rates in international markets. And American corporations raised $41 billion of debt, including GE Capital's $4 billion offering—the first US financial firm issue not guaranteed by the FDIC since November. Perhaps investors are starting to choose higher-yielding corporate bonds over low-yielding government securities.**

In any case, economic hardship won't be confined to one or a few countries, and as governments spend more, new funding issues could crop up. Yet the risk of too little stimulative action continues to outweigh too much—and so far, both in the US and abroad, the consensus mostly agrees. We expect stocks will price in today's tidal wave of monetary and fiscal stimulus long before its effects are fully evident economically.

*Source: Goldman Sachs Global ECS Research
**Source: Bloomberg