Monday, 29 November 2010

Why are bund yields rising? Because the ECB is doing something right

Rising German bond yields over the week since the Irish bailout have been interpreted (here and here) as an increase in default risk to the German government.

But surely there is another "risk" much more likely to explain this increase. And that is the simple risk of inflation.

The Irish bailout must make inflation more likely - through one of two routes.

One: ECB liquidity support, i.e. lending to Irish and other banks, might not be repaid - which will result in an effective increase in money supply unless the ECB then tightens monetary policy to reduce it, which would be politically quite difficult. The ECB lending is secured on bank assets, but we know that those assets might not be worth 100% of their nominal value. So in the case of a bank default, the ECB has printed a billion euros to buy an asset which repays less than a billion euros of principal.

Two: monetary policy may be deliberately loosened, either to help reduce the pressure on sovereign borrowers or simply to increase inflation and growth.

In either case, the money supply increases, eurozone inflation is higher, and the real value of bunds falls. This can easily account for the small increase in yields which we have seen.

The euro has also fallen around three per cent in the last week, which provides further support for this theory. The idea that the German state is going to default is as unlikely as a default anywhere in the world, with the possible exception of Switzerland.

And that eurozone inflation? Much needed, as you can find out from reading the last two years of Scott Sumner's blog. Although he's recently pointed out that it's much better to express the policy goal as "higher wages" than "more inflation".

Another small note on this same subject: German business confidence is at its highest level in 20 years. Maybe this is an result of the implied monetary easing; more likely it's due to growth in China and sustained recovery in Germany itself. But either way, it's another reason for bund yields to go up and certainly doesn't imply that the German goverment can't pay its bills.

1 comment:

Duncan said...

CDS spreads also moving though. Which would imply the bund move is risk related?