Gentlemen Prefer Bunds (German Bonds)

On March 10th, U.S. stocks declined for a fifth day.  The reason most often given was concern over Europe. Bond prices on most European bonds have declined, producing higher yields. Investors have flocked to safe havens, such as U.S. and German bonds, pushing those prices up and those yields sharply lower.

Spain’s ten year bonds are now yielding 5.8%. Spain is entering its second recession in three years, unemployment is at 23% and the government expects the economy to contract about 1.7% in 2012. The Spanish stock market is the lowest since March 2009. The concern is that austerity measures could have the effect of further depressing growth and creating a vicious cycle in which more budget cuts are needed to balance the books. Italy’s ten year bonds are not far behind, yielding 5.5%.

French business confidence has stagnated and factory output has dropped. Manufacturing production fell 1.2% in February and the Bank of France said its surveys suggest that GDP didn’t expand in the first quarter. On March 31st the Economist characterized France, Europe’s second largest economy, as “A Country in Denial.” Comparing them with Greece, the Economist indicated that “the Greeks know that free-spending and tax-dodging are over. But (France) has yet to face up to its changed circumstances.” Upcoming French elections demonstrate the reluctance to change. Front-runner Socialist Francois Hollande has promised to rollback most of the recent pension-age reforms and install a 75% tax rate on the wealthy. None of the candidates are offering radical reforms or austerity programs seen in other European elections recently. Yields on France ten-year bonds are currently 2.93%. But that could move up quickly and significantly right after the elections.

Germany is the one major bright spot. German ten year bonds are yielding 1.8% (as compared to ten year US treasuries yielding 2.04%.) Germany’s exports are up and its trade surplus surged in February. The above chart tells it all. German productivity has far outpaced the rest of Europe in the last eight years. Nominal unit labor costs have stayed almost level in Germany, while growing in Italy, Ireland, Spain, Greece and France. During this period, only Ireland has seen their costs drop, starting in 2008, as their labor accepted pay cuts and productivity increased. To get on par with Germany, all five countries would need a 30% pay cut to become competitive. It’s unlikely we can expect that to happen any time soon.