Poor German auction spells tough times for euro

Weak demand at a German debt auction suggests investors are starting to shun even the eurozone's strongest economy, which could trigger more losses in the shared currency as many shift from euro-denominated assets to safe havens outside the region.
As Italian, Spanish and even French yield spreads have blown out to record levels in recent weeks, the trend has been for portfolio flows to switch into German Bunds, resulting in no foreign exchange outflows from the eurozone.
Those flows, combined with talk of repatriation of capital by eurozone banks desperate to shore up their balance sheets as money markets seize up, have been cited as reasons behind the euro's recent resilience around $1.34.
But that appears to be changing and on Thursday the euro slid to a 7-week low at $1.3316 on trading platform EBS.
Germany sold barely half the bonds it put up for auction on Wednesday, when a buyers' strike against the low yields on offer was fuelled by fears that Berlin could not remain immune from the crisis engulfing its heavily indebted euro partners.
In a sign that investors are cutting exposure to the eurozone as a whole, 10-year Bund yields converged with UK gilts for the first time in 2-1/2 years.
Normally, positive yield differentials would be considered a reason to buy the euro. But analysts said investors are now more likely to sell the shared currency because of fears that Germany may be forced to underwrite the fiscal excesses of weaker eurozone economies. Those worries could push the euro to $1.25 or lower by early next year, some analysts say.
"Some people are now saying if you cannot sell the Bund (at auction) you cannot sell anything. Traders will see German yields higher and the euro falling and say that is not a good sign. The eurozone crisis is just getting going," said Geoff Kendrick, FX strategist at Nomura.
Analysts described the recent widening of differentials between benchmark Bund yields and returns on the bonds of weaker economies as asymmetric. Earlier in the crisis, when peripheral bond yields rose German yields tended to fall.
"When German Bund yields no longer drop while the other side is widening, we have liquidation of these peripheral bonds as well as simultaneously a flight out of the euro. This means the euro is much more vulnerable to widening of the spreads," said Hans Redeker, global head of FX strategy at Morgan Stanley.
At 2.15 percent, 10-year German yields are still roughly a third below levels seen earlier this year, and investors are unlikely to dump Bunds as they dumped Italian and Spanish debt.
But Stephen Gallo, head of market analysis at Schneider Foreign Exchange, said if weak demand for German debt escalates into an outright Bund sell-off, a huge proportion of flows that have remained within the eurozone would desert the bloc.
"We may get to a point where Germany starts to get pressured, capital is going to be drying up and then the euro could drop quite low, to $1.25 or less in a matter of days," Gallo said.
In a scenario in which Germany comes under pressure, analysts said the portfolio flows could dry up fast. The latest European Central Bank data showed 20.7 billion euros of net portfolio investment flowed into the eurozone in September, at a slower pace than August when 31.9 billion euros came in.