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Euro zone aid deal to dim German bond allure

Source: Reuters - Fri 14th May 2010

A $1 trillion euro zone aid package to ring-fence the Greek crisis is likely to undermine the safe-haven status of German Bunds as the region's biggest economy will have to foot the lion's share of the bailout bill.

The aid package, hammered out by European Union finance ministers, central bankers and the International Monetary Fund, was the biggest since Group of 20 leaders rolled out support measures after the collapse of Lehman Brothers in 2008.

German bonds, the main beneficiary of the escalating euro zone sovereign tensions, saw a sharp unwinding of flight-to-quality trades as central banks bought fringe sovereign debt from the market as part of the package.

The German Bund yield surged 19 basis points to almost 3 percent on Monday in its biggest daily gain since mid-2003 as safe-haven flows diminished.

"I don't think Bunds should yield much less than 3.25 percent and we've been below 3 for some time now. There's a huge flight-to-quality, a safe-haven premium in the Bund market that needs to gradually unwind" HSBC strategist Steven Major told Reuters Insider Television.

"Germany is going to have to stump up a lot of money here and the actual cash and contingent liability. All of this threatens the status of the Bund market, compared to some of the others."

Germany's cabinet approved on Tuesday the biggest national contribution to the emergency aid intended to stabilise the euro even though Bundesbank chief Axel Weber has voiced open criticism at the central bank bond purchases.

ECB President Jean-Claude Trichet said on Monday the purchases would be sterilised - a move that neutralises the inflationary impact of effectively printing money to buy bonds - but declined to say how. This fuelled speculation that the sterilisation measures could involve selling Bunds to buy riskier debt.

Underlining the burden on richer European states, Moody's Investors Service said the package was marginally credit- negative for the stronger euro zone governments.

CONVERGENCE

However, a sharp sell-off in Bunds in favour of the periphery is not a one-way bet because of investor doubts that the bailout package offers a long-term solution and whether Greece and other indebted euro zone states can deliver budget deficit cuts.

Peripheral and German yields are unlikely to converge at anything like the pace seen in the late 1990s, in the run-up to the adoption of the euro, because of the differences in fiscal health among the highly indebted states.

"I don't think you are going to see a big tightening in spreads because when you look at Spain and Ireland, and to some extent Portugal, the levels of yields and spreads you are seeing are probably consistent with their underlying fiscal positions" said Mark Schofield, a strategist at Citi.

Greek yields have plummeted from record highs and the curve has flattened sharply, with the two-year now near par with the 10-year around 7 percent as immediate fears of a liquidity crunch recede.

The risk premium on 10-year Greek bonds over German benchmarks has compressed by more than half from record peaks to just under 500 basis points.

Michael Leister, a strategist at WestLB, expects the spread to tighten to lows seen in February around 300 bps after which it might prove harder to see further tightening if Greece and other peripherals fail to deliver on deficit cuts.

"The volatility is going to remain high. By no way is this going to be a one way street."

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