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Considering how hard it’s been for President Obama to get the House and the Senate to agree on a concrete stimulus, imagine how hard it would be for the European Commission to do the same in a fair manner for its 16 member nations. Although the International Monetary Fund predicts that the total output of the Euro-zone will decline by 2%, the fiscal response from the heads of the region has been a mere 0.5% of GDP in 2009. Compare this to the United States, which has already spent close to 7% of GDP, and plans to double that amount are in the works. One of the major road-blocks for the Europeans has been that some of their weaker economies are unable or unwilling to implement large fiscal stimuli.

Without a large fiscal stimulus package and a shrinking GDP, it is safe to assume that the Euro-zone will continue in a recessionary environment for most of 2009. As a result, we can expect inflation, which has historically averaged a little over 2%, to slow down considerably. The January inflation rate was 1.1% - the lowest level in almost a decade. This should give the European Central Bank (ECB) incentive to cut interest rates further (the last rate cut to 2% coming in January) and they could go as low as 0.5%, about 150bp lower than the prevailing rate.

A drop in short-term rates would cause the yield curve to steepen and increase the spread between short-term and long-term government bonds, making longer term bonds more attractive to current investors. Furthermore, a greater spread in one year has historically been correlated with strong GDP growth the next. Therefore, if the spread actually rises, we can expect to see a recovery of roughly a year from that point.

Furthermore, the European Commission predicted that the current account deficit will more than double from 1.7% of GDP in 2008 to 4.0% in 2009 (and 4.4% in 2010). Not surprisingly, some countries posted worse numbers than others, for example Ireland and Spain had forecasts of 11.0% and 6.2% respectively. This means that the Euro-zone will need greater levels of portfolio investment to balance its deficit. With the United States trying to push “Buy American” provisions in its legislature, and most emerging economies reeling from their own crises, it seems that much of the incremental foreign investment should be coming from the $1.95 trillion of foreign reserves that China currently holds.

More recently, the IMF has been quite vocal in backing the idea of a common European bond that would support some of the weaker economies of the Euro-zone, such as Ireland and Greece, “who have to pay hefty premiums over the other nations to finance their debt”. The Managing Director of the IMF, Mr. Strauss-Kahn, said that he “supports the initiative” and thinks it’s near essential in order to avoid a near-term crisis. However, until this idea materializes, investors considering the region can put their money in German government bonds, which have historically been a proxy for the region.

Historically, the Lehman Global Bond Index benchmarks 25% of a global bond portfolio for investment in the Euro-zone. The potential of a steepening yield curve (good for long-term bond investment) is really overshadowed by the increasing dependence on foreign investment and political debate in the region; Therefore, I would recommend putting only about 10% of your portfolio in long-term German bonds that currently offer a yield of about 3%.

Source: How Do Economic Drivers in the Euro-zone Influence Your Bond Investments?