A signal to watch for

By Buttonwood

THINGS need to get worse before they can get better. That is the view of many commentators on the euro zone crisis, who think that only when complete catastrophe seems imminent, will European political leaders take the necessary action. (They don't always agree on what that action might be but it is usually some combination of unlimited bond purchases by the European Central Bank and moves towards fiscal union.)

Richard McGuire, the fixed income strategist at Rabobank, is very much in that camp. He argues that most of the daily headlines, such as changes in Greek and Italian governments, don't matter. The fundamental problem is one currency and 17 separate fiscal authorities; until that situation is resolved, there will be no solution. Austerity policies won't work.

But Mr McGuire has also figured out what the next stage of the crisis will mean for investors. Up until now, the obvious strategy has been to buy German government bonds and sell just about everything else, on the grounds that, if the euro zone does break up, you want your money to be in Deutsche Marks. But if European politicians do unveil a rescue plan, that will either mean the core countries assuming the burden of eurozone debt, or it will mean that long-term inflation risks will have risen.

At that stage, investors will pile out of long-term German government debt and into the short-term debt of countries like Italy (since the credit risk will have disappeared). Given that plans always leak, that's a signal to watch for; a sudden rise in German bond yields. Mr McGuire thinks the crunch will come in the first or second quarter of 2012.