What paying Berlin to borrow for 30 years tells us about Europe

When the European Central Bank was building its new headquarters on the banks of Frankfurt’s Main river, stenciled on one of the hoardings around the construction site was an image of a suave Mario Draghi at the roulette table, chips stacked, with Angela Merkel the glamourpuss, at his side.

The graffito, dubbed Casino Royale, symbolised an era when markets viewed the ECB’s urbane central bank chief as a James Bond-style figure who would bet the house and win the battle to save Europe from disaster. Fittingly, it was bought by a New York fund manager.

Ah, the halcyon days of 2013.

Cut to 2019, and the spectre of an ever-worsening global trade war is scaring the living daylights out of European investors to the extent that even Mr Draghi’s cunning is not enough. A flight to safety has sent debt prices rocketing, with north of $16tn of bonds now trading at negative yields (a big chunk of them euro-denominated) — meaning that, if investors end up holding them to maturity, they’re paying for the privilege of holding the (relatively) secure assets.

A more accurate artistic representation of the current mood in Europe, then, is ‘The K Foundation Burn A Million Quid’. A case-in-point came from Ms Merkel’s government today when it issued a 30-year bond with no coupon at all. Investors who stumped up the cash for the €2bn-worth of debt did so at a price that means they will in effect pay 11 basis points per year to Berlin to borrow the sum.

Of course, the actions of the central banks themselves have contributed to this cash burning exercise. Mr Draghi could, in the coming weeks, throw in his few remaining chips and promise to buy more government bonds under the ECB’s €2.6tn QE programme, which may make German sovereign debt even more expensive. And with the interest rate on deposits held at the eurozone’s central bank now minus 40 basis points — and set to sink lower still — 11 basis points doesn’t look all that bad a return.

What it points to most of all though is the feeling that, despite the cheap borrowing on offer and the region’s exposure to trade tensions, the governments here will not radically ramp up spending, and therefore the economy will remain sclerotic for decades to come.

In the meantime investors may tell themselves that these bonds can become ever more expensive and that they are a snip even with a zero coupon and negative yields. As the FT’s Laurence Fletcher pointed out, this is not totally delusional [with our emphasis]:

Fund managers based outside the eurozone can profit from buying Europe’s negative-yielding government debt thanks to an uplift from hedging the currency. That is because such hedges are based on the relative levels of short-term interest rates. These are much higher in the US than in the eurozone, meaning dollar-based investors are effectively paid to hedge their euro exposure back into dollars.
For instance, a two-year German Bund currently yields around minus 0.88 per cent. However, after hedging the currency, this becomes a positive yield of around 1.9 per cent for dollar-based investors. For a US-based investor, this is better than buying a two-year Treasury.

A lot can happen in 30 years though. We could see a remake of Casino Royale, with another pairing like Draghi and Merkel that manage to revive optimism. Or a wave of stagflation that would only deepen investors’ losses.

Either way, some people are going to end up looking daft — a bit like the K Foundation. Once the mass of £50 notes were burnt, it tried to sell the ashes as art. Eventually they found Rene Gimpel, a gallery director, who agreed to flog the detritus of this “fantastic, iconoclastic gesture” for £1,000. “I’d accept £850,” he said.

A trade for our times.

Related Links:
Markets to Germany: “Please borrow”. Germany: “Nein.”; — FT Alphaville
Meat tax gives Germans something to chew on — FT Alphaville