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Klaudius Sobczyk
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Klaudius Sobczyk is Founder of the Advanced Dynamic Asset Management an innovative company focusing on delivering returns with predefined risk structure. Klaudius Sobczyk has 17 years of experience in financial markets. Since 1993, when Klaudius became independent financial analyst, he gained an... More
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  • German Rates, Quo Va Dis? 0 comments
    Jul 1, 2012 4:06 PM

    European politicians did decide the next bail-out plan on a 25th EU summit since the crisis begun. This sounds like the logbook of a captain which has just to jot down the events which just happened. However, those events do have an ongoing profound impact on equities and interest rates.

    Investors have been concerned with interest rates which reached 6% or 7% for Italy and Spain. Also German interest rates made investors feel uneasy with 1.5%. Those interest rates might have some psychological impact and subjective impact on the sensitive feeling of markets and investors but do they actually mean anything? Why should 7% be better or worst then 6%? Is 1.5% appropriate for German or shall we be closer to 5% or any other percentage, which we may feel appropriate about? Let us look briefly for a simple but a very enlightening explanation.

    A simple formula which I have learned early in my days says:

    Nominal interest rate = real economic growth + inflation + risk premium

    The current markets and financial instruments available deliver all the parts of this formula which may shed some light on why the market may feel more comfortable with one interest rate level for a selected country but can be disturbed by other interest rate level for other country. Subsequently, just two examples to make it more understandable. I will just use rounded numbers and approximation to make it simple.

    German interest rates were just 1.5% on a ten year bund. At the same time real economic growth was at 1.1% for the last 12 month. Add to it inflation of 1.9% and you arrive already at 3%. This would mean that the risk premium is negative at 1.5%. Just to remind you that the current CDS for Germany is around 1%. CDS is seen as the risk premium attached by the market participants to the probability of sovereign default. If we take objective market number and plug it into the formula the calculation would look like this:

    Real economic growth (1.1%) + inflation (1.8%) + CDS 10 year (1%) = nominal 10 year yield (4%)

    This obviously is a far cry from 1.5% which are available on the market.

    Now Spain is brief

    Real economic growth (-0.4%) + inflation (1.9%) + CDS 10 year (5.5%) = nominal 10 year yield (7%)

    This is very close to the 10 year yields observed on the market.

    It appears that the markets are more rational about Spain then Germany. Either German rates need to move toward 3.5% or 4% or investors are expecting some very negative numbers for inflation and real economic growth. In order to make the current yield rational investors must expect the real economic growth and inflation to approach 0% in the coming months. This would be the same scenario as in 2008 when the inflation dropped to -0.5% and growth contracted to well below 0%.

    Financial markets can be insane for a while but those same markets are able to correctly price most of the countries at the moment. This leaves only one door open. German yields need to rise and sanity must return. Markets participants are not prepared for German yields above 3% in the coming months. This can be a very difficult and trying period for the markets in general.

    Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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