Achtung Baby!

Surprisingly negative news from the German bond market this morning set the stage for yet another day of losses in global equities.  The $6 billion Euro 10-year bond auction failed to find adequate bids, resulting in the Germans being forced to take down over $2 billion Euros of their own bonds.

This was the worst bond auction in Germany since the introduction of the Euro.

The ripple effects were instantaneous, with yields in Italy and Spain rising to the point where the ECB was forced to intervene and lend pricing support.  Further, the Euro fell dramatically versus the USD and the US equity futures tumbled.

Since November 15, the Dow Jones Industrial Average has fallen nearly 7%.

The prevailing school of thought regarding this auction goes something like this:  German bond buyers essentially went “on strike” in order to pressure Germany into allowing the ECB to exercise more power to stem the crisis.  It would be nice if that school of thought turns out to be true.  Otherwise, the word contagion comes to mind.

But, Germany wasn’t alone in pressuring the markets today.  China and Belgium had a hand in the mess as well.  China’s Purchasing Manager’s Index fell to 48 (a number below 50 indicates contraction).  This sent commodities (as well as stocks) broadly lower.  As for Belgium, a rumor began circulating that they will be unable to pay their share of the Dexia bailout.  This would place the burden of the bailout on France — and this is a burden that could result in a French debt downgrade.

As is usual on these “flight to quality” days, US Treasuries were aggressively purchased; with the 10-year yield falling to 1.9%.  This is somewhat ironic, considering the uber-committee managed to squander its opportunity to begin working off the US deficits just a few days ago.

We continue to favor high cash balances and well-hedged income positions in this environment.  Holding cash with a negative real yield is painful… but not nearly as painful as the alternative.