The German view of market psychology

Does Germany have a superior understanding of the psychology of bond market investors?

It’s a pertinent question because David Cameron is lobbying today in Berlin (doubtless in vain) for Angela Merkel to allow the European Central Bank to arrive like the cavalry on the battlefield of eurozone debt.

The Prime Minister – along with many market analysts – believes that this war can only be won with the full firepower of the ECB deployed.

We know Merkel does not believe that. But what is the thinking behind her resistance? Some answers can perhaps be found in the interview with the head of the Bundesbank, Jens Weidmann (pictured), in the Financial Times earlier in this week.

Asked about the option of getting the ECB to increase its purchases of Italian bonds to ease the pressure on Rome, Weidmann replied that greater ECB involvement simply would not work in calming investors:

“You won’t solve the crisis by reducing incentives for the Italian government to act.”

Mr Weidmann also suggested that the “market turmoil” over Greece was due to the fact that Athens has not been implementing its reform plan properly (rather than, as most people believe, because the country’s debt burden is simply too large and needs to be restructured).

The Bundesbank chief wasn’t finished there. Weidmann also suggested that the grand plan agreed upon in Brussels last month of leveraging the European bailout fund would not be effective. Why?

“Markets will look through financial engineering and it is clear that all the leverage will in the end increase the expected loss on the guarantees.”

A picture forms. Weidmann clearly believes that bond market investors see the world exactly as he does. It is a world in which the bond market storms would abate if countries would only enact reforms to reduce their debt and deficits. And to some extent Weidmann even seems to relish the rising yields on peripheral eurozone debt since it is forcing reluctant governments to enact such austerity measures.

The counterargument that, while fiscal reforms are necessary and must be pushed hard, the markets will not stop panicking until the ECB commits, like other central banks, to act as a lender of last resort to sovereigns, is simply rejected out of hand by Weidmann.

One might argue that the Bundesbank analysis of market psychology has been pretty much disproved over the past 18 months as the eurozone crisis has got progressively worse, despite Europe’s official response moving no faster than the German imposed speed limit.

But Weidmann would, one senses, argue that the situation has deteriorated because governments have not been fulfilling their fiscal commitments, not because the eurozone’s response has been too little too late.

It’s a world view that cannot be challenged by evidence. The eurozone could even break apart, under unbearable bond market pressure, and Weidmann and others could blame the fact that governments did not cut enough.

Frightening.

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• greggf

  Actually Ben, I think bond market investors as well as most people believe that Greece’s debt burden is simply too large and needs to be restructured. The investors expect a default, or restructuring, so that they can cash in their credit default swaps.
  However although Greece (and much of the rest) is awash in debt which it can’t possibly repay, the current power structure in the EU has a vested interest in delaying that fact. The crumbling of the sovereign debt (and it credit default swaps market) will continue until something gives.
  If bond investors can’t collect on their insurance (CDSs) because of politics they will have no alternative but liquidate their holdings. 
  In the limit I suppose the Bundesbank might be the lender of last resort….