German Chancellor Angela Merkel has extracted the necessary promises from Greece that they will be good in future and properly respect the rules of the euro-zone’s Growth & Stability Pact (i.e. bring their budget deficit back down to less than 3% of GDP).  Whilst the bigger & stronger countries within the euro haven’t quite worked out all the details yet, Germany has sent a “clear political signal” to Greece and the wider financial markets that (with the independent IMF checking that Greece keeps to its promises) they will support Greece if it cannot borrow enough money at a reasonable rate from government bond investors.

This is a pivotal moment in the course of the euro-zone and its monetary union.  Germany is the key player and can make-or-break any smaller country which gets into trouble raising money from government bond investors.  Bringing in an independent outside entity, such as the IMF, to play policeman will allow countries to sell difficult tax-raising budgets to their voters.  Having given up the Drachma for the Euro, Greece no longer has a central bank which can print money to finance its deficit and/or devalue its currency (both of which are exactly what the UK has done over the last year or so).

An important precedent has thus been set and Germany has used this Greek crisis to get what it wants, namely the peripheral nations are going to have to play by the rules from now on or they will get hung out to dry. This is going to be tough on the economies of the peripheral countries and their growth is going to suffer as they shrink their budget deficits back down from 10%+ to below 3% of GDP over the next 3 to 5 years. 

However the message to players in the government bond markets is clear – the great convergence trade (which last took place in the run-up to the euro’s birth on 1st Jan 1999) is now back on.  Spreads over bunds have now tacked back onto a tightening trend and, whilst they will not converge all the way down to 20bps or so, it is going to be worthwhile buying the dips every time the yield spreads over bunds widen back out again.