Evercore Pan Asset

The markets and the media cannot get away from those 10 year bonds. For years most of us left 10 year French or Spanish government bonds to specialists. They were about as exciting as watching paint dry. You needed to have a view on which way interest rates might go, but not much else worried you.

In the early days of the Euro some in the markets seemed to think debt from the southern states had suddenly become as trustworthy as German or French debt. After all, they shared a currency, an interest rate and a Central Bank. Didn’t that mean the southern states just offered you cheaper Euro debt? Wouldn’t one day it all amalgamate? What could go wrong, as there was no special currency risk or short term interest rate risk to concern you when choosing between Euro area states. The idea that one or more of them might not repay the money seemed ludicrous to the optimists.

Now people know differently. The fascination today with 10 year Euro area states bonds is simple. It is the bond markets that will decide if the Euro survives or not. If the markets push more countries into the position of Greece, with bond yields through the roof, more Euro area countries could be forced into default or inability to repay what they have borrowed. As fears mount that other countries might do a Greece and refuse to repay in full, so more bonds go down and more interest rates soar. They will reach a point where the only sensible option is to let stressed countries leave the Euro.

The short term fix is for the European Central Bank to be given full support to buy up bonds from weaker member states, on a sufficient scale to keep the prices up and the yields down. Then these countries can carry on borrowing at affordable levels. To do this the ECB may well have to print the money, as no-one in Euroland is currently flush with cash and ready to spend it on each other. The zone as a whole has been hoping China would lend them money for a Christmas present, as the Germans so far have been out of sorts when it comes to paying.

Many in the markets think Germany is bound to relent and allow this way of delaying the disaster. They can argue that the UK, US and Japan have done it. Germany may well want to keep the Euro, as she can export easily throughout the zone at the locked in exchange rates from the predecessor currencies. Germany has plenty of political capital invested in the scheme. So it may prove.

There is a contrary view. Germany after all did not wish to commit large financial resources to preventing the market destruction of the Exchange Rate Mechanism. She did not come to the aid of the UK when sterling was badly threatened. Some would say the UK has always been different, so that is not surprising. Nor did she manage to spend enough to save Italy. She gave up, walked away, and watched as that project for EU integration was struck down by the foreign exchange markets.

Germany has had recent bitter experience of the high costs of a currency union between two countries with different living standards and different levels of competitiveness. The amalgamation with East Germany came at a very high price, which many West Germans resented. They were at least citizens of the same country, with many ties of kith and kin. The area being merged was much smaller than the Euro zone.

The recent unsettling of the German 10 year bond rate can argue either way. Germans who do not want to pay the bills for the Euro will say it is proof of the damage the Euro project is doing. Germany on her own could borrow more cheaply. Others in favour of the Euro says it shows Germany has to hasten to fight back against the markets. She needs to tell the markets the full might of a newly invigorated ECB will be set loose to counter the bears.

Mrs Merkel is hinting she wants to try a rescue. The problem with it is it does little to solve the underlying problems. Greece, Portugal, Spain and Italy are not competitive enough compared to Germany. All Euro area countries have borrowed too much. Their combined credit worthiness may not be that highly prized, given the rapid deterioration we are likely to see in their growth prospects and public finances. The west has been living beyond its means for too long, and is struggling over how to adjust.