Next Trade Of The Century - Short German Bunds?

The eurozone meltdown that we anticipated and followed up on recently continues. Sovereign yields and spreads over German government bonds (also referred to as Bunds) are still on a frighteningly steep upward trajectory. While interbank funding in euros has eased and appears stable for the time being, interbank demand for U.S. dollars continues to intensify (often a sign of looming financial risk, as we noted yesterday). Against this backdrop, some smart market participants and pundits have referred to a short bet on the euro (selling euros today and buying them back in the future, which will be profitable if the value of the euro declines during that time) as the next 'trade of the century' after shorting mortgage and mortgage-related securities going into 2008-2009. In a similar vein, we believe that sophisticated investors and speculators might want to consider taking short positions in Bunds, based on the following rationale.

The eurozone (via the European Central Bank or ECB) has the means for adding to the stock of net financial assets, but as an institution it suffers from mainstream macroeconomists' persistent ignorance of how critical this function is to a financial economy, and remains stubbornly committed to it, not just legally through its charter, but also culturally, as its two main national influences, France and Germany, have long been hard money advocates.

In the late 1920s and early 1930s, the Bank of France (the country's central bank) led the charge toward resetting gold's nominal parity at its pre-WWI level, turning what might have been a multi-nation recession into the worldwide Great Depression (the U.S. Federal Reserve was not innocent either). In the 1960s, under the post-WWII Bretton Woods monetary system, French President Charles de Gaulle railed against U.S. budget deficits (subscription required), and France increasingly redeemed its U.S. dollars for the Treasury's gold until President Nixon finally closed the '! gold win dow' in 1973, bringing the Bretton Woods system to an end.

Germany's bent for monetary restraint is firmly rooted in its experience with the staggering hyperinflation of its post-WWI Weimar Republic in the early 1920s, a point emphasized recently by Jens Weidmann, president of the Bundesbank (Germany's central bank) and member of the ECB's governing council (an influential member, according to the Financial Times), in a speech in Berlin on November 8:

One of the severest forms of monetary policy being roped in for fiscal purposes is monetary financing, in colloquial terms also known as the financing of public debt via the money printing press...[The prohibition of monetary financing in the euro area] is one of the most important achievements in central banking [and] specifically for Germany, it is also a key lesson from the experience of hyperinflation after World War I.

Some degree of 'hardness' in money is fine and good, and hyperinflation is certainly one of the most severe forms of government malfeasance. But economists and bankers like Weidmann, in spite their credentials, exhibit a glaring intellectual gap relating to the concept of net financial assets under a soft currency system. Simply put, if money is going to be an inconvertible creature of the state rather than being based on the existing stock of precious metals and future additions to it, then the only way that users of that currency can, in the aggregate, accumulate precautionary savings and successfully lend or borrow money is if the government sector, as the monopoly provider of the currency, runs sufficient and (under most conditions) ongoing deficits.

Weidmann demonstrates this glaring intellectual gap, and articulates some of the astoundingly wrong inferences it leads to, in comments attributed to him in a recent Financial Times article:

Mr Weidmann highlighted the stance being taken by the Bundesbank by arguing governments, not centra! l banks, were mainly responsible for ensuring financial stability. Mario Draghi, the ECB’s new president, has said it is not the ECB’s job to act as lender of last resort, but Mr Weidmann went further, saying such a step would breach Europe’s ban on “monetary financing” – central bank funding of governments.

“I cannot see how you can ensure the stability of a monetary union by violating its legal provisions,” Mr Weidmann argued. “I don’t see how you can build trust in a system that violates laws.”

Mr Weidmann said current Italian interest rates levels were “not such a big issue” in the short run. “What we are facing in Italy is an acute confidence crisis, and only the Italian government can resolve that crisis.”

Since May last year, the ECB has been buying eurozone government bonds – a move opposed by the Bundesbank – but sees its role as limited and aimed only at ensuring functioning markets.