Weak demand at an auction of German bonds - normally seen as a safe haven in times of market turmoil - has raised fears that the eurozone's largest economy is being drawn into the sovereign debt crisis on the periphery.
European markets closed at their lowest levels for seven weeks on Wednesday after, in a €6bn auction of 10-year bonds, the German government was only able to sell €3.6bn at an average yield of 1.98%. The country's debt metrics are far superior to any of the struggling countries in Southern Europe, but markets are worried that the failure to agree on a comprehensive plan to resolve the eurozone's debt problems are now weighing on stronger economies.
The main European indexes rebounded on Thursday, after German business sentiment beat expectations. The DAX rose 1.58% and the French CAC-40 was up 1.61%. The FTSE 100's recovery was slower, gaining 0.77% in early trade.
"Before we get too excited, the main problem with the Bund auction was that there were not enough buyers at the prevailing price, not that appetite has been completely exhausted for Bunds," Deutsche Bank strategist Jim Reid wrote on Thursday morning.
"Had yields backed up a few basis points more, then demand would have likely been much stronger. Nevertheless the auction is a warning sign to Germany that a continued hardline stance might be counterproductive even if all possible alternatives will only encourage moral hazard. Germany is stuck between a rock and a hard place and yesterday may accelerate some of their thinking."
Some have suggested that the yield was simply set too low, but, as Simon Derrick, currency strategist at BNY Mellon, said on Thursday, investors have been shying away from longer-term German debt, preferring to use bonds with shorter maturities as their safe haven. This could reflect fears that the longer term impact of the crisis on Germany will be more severe than the short term.
Indications in the German press - subsequently denied - that the government might be softening its resistance to eurobonds - debt instruments issued jointly by the 17 countries of the the eurozone and founded on the sovereign ratings of its economic giants - has also increased market worries that Germany might have to carry an even greater financial burden if it is to keep the single currency area together.
Eurobonds are mooted as a potential solution, offering cheaper financing for peripheral countries, who have struggled with an unsustainable cost of borrowing. European Commission president Jose Manuel Barroso announced a consultation on such 'stability bonds' on Wednesday, meeting from resistance from German Chancellor Angela Merkel. Speaking in parliament, she said that the calls were "extraordinarily inappropriate."
Merkel has also refused to consider a proposal to take the shackles off the European Central Bank (ECB) and allow it to intervene without limits in bond markets, turning it into a lender of last resort for the eurozone.
"Whatever the reason, the simple fact is that yesterday’s bond sale has undoubtedly shaken investor confidence in German paper," Derrick said.
How Germany responds will depend on the balance between its desire to swiftly resolve the crisis and its instinct to defend its bond markets, he added.
"It seems reasonable to suppose that the German government and the Bundesbank will have taken yesterday’s auction result very seriously indeed… At the very least it indicates that official opposition to the idea of eurobonds will harden from here," he said. "However, it also indicates that German officials will now feel a sense of urgency to find a rapid and lasting solution to this crisis in order to protect the credibility of its domestic market."
Signs of pressure on the other safe-haven AAA-rated economies - the Netherlands, Austria and Finland - suggest that this is not an isolated problem, Stephane Deo, economist at UBS, said.
"We think it is about the market attempting to price a breakup of the Euro," Deo said. "Being in Asia this week visiting investors, we can say that the lack of solution to the European crisis leave them to question the existence of the euro and the willingness of governments to do what is appropriate to keep the euro together. As a result investors may seek to disinvest from Europe. In a case of a breakup even Germany is unlikely to be a safe haven, hence the sellers last week and yesterday morning.
"On the surface, the German position seems to remain stationary: no Eurobonds, no ECB as a lender of last resort… Yesterday’s price action clearly shows that the market is begging for different answers."