The Short Opportunity in the Eurozone Crisis

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Michael Shulman submits:

Is the growing crisis in the Eurozone a trading opportunity with an acceptable risk reward ratio, given the total involvement of often unpredictable politicians? The current crisis, which is going to be hot, then cold, then hot again, has major short and long term implications for the dollar. The euro going down means the dollar going up, and the dollar going up means equity markets going down or on certain days, sideways. Current trading, and trading since late fall, has been driven by the "dollar carry trade" and this interest in equities is driven by a falling dollar.

The opportunity? Plays on a rising dollar, equity markets facing tailwinds, rising Treasury bond prices, a falling pound, falling euro and rising Treasury bills. Also, the continuing fall of the euro and rise of the dollar will have a material, negative impact on American companies doing business in Europe, from Procter & Gamble ( PG ) to Hewlett-Packard ( HPQ ), while having a positive impact on European companies deriving a majority of their revenue outside the eurozone. This translates into a variety of opportunities that may play out, not just during a currency crisis but for several months.

The Macro Economic View

Over the past thirty months, governments around the world have borrowed or printed money to replace the value lost as private sector debt failed or, due to the recession induced by the financial crisis, paid bills and transferred payments to an increasingly restive population. And now creditors are saying we may not want as many of your bonds in the future as we do now - and since others think like we do, you may have trouble rolling over existing debt, and that means you need to change the way you are spending money. And with that comes a crisis.

Credit Markets and the Current Crisis

The credit markets are voting in several ways. Last week, they did not buy as many Portuguese bonds as Portugal wanted to sell and the cost of credit default swaps (insurance on bonds) skyrocketed for certain countries with gigantic deficits and a need to roll over debt. Then, when rumors of a bailout hit Tuesday, they fell 19%.
That is the first part of the crisis; the other part is the specific countries and their membership in the European Currency Union. I am talking about Greece, Portugal, Spain and Ireland. They all use the euro, they all have huge debt and deficits, and the credit markets are uncertain what is going to happen next. The European currency union unites countries in a common currency - the euro - but does not force them to manage their economies and spending outside of guidelines that include budget deficits no greater than 3%, and that are, to date, poorly enforced if enforced at all. In the past, when a country had a recession and structural deficit, it could make adjustments in its currency to solve at least part of the problem. Not anymore, if you are using the euro.

And through its public face, the European Central Bank and its president, Jean Claude Trichet, the union is saying "tough"; the membership agreement says there will be no bailouts of member nations when they do what Greece and other nations are doing. At the same time, no one wants the monetary union to fail, which it could if selective members, such as Greece, are kicked out.

Greece is the beginning of the current crisis. It recently told the world it had submitted false budget data and its budget deficit was not slightly above 3% but slightly above 12%. The country overspent on the Olympics and has a political system that doles out transfer payments and benefits to groups that strike, which is almost everyone from farmers to teachers. And to reduce the deficit by 2010 to 3%, massive cuts in these payments must occur - and the credit markets do not believe this will happen. But the end game is Spain.

Spain has been in a deep recession due to the collapse of a massive real estate bubble, by far the worst in Europe. The country has twenty percent unemployment and massive deficits that are growing daily. Greece has an economy the size of Mississippi and debts less than those of California; Spain is another story altogether. It is a big nation, not too long ago the fastest growing in Europe, alongside Ireland. These are not economies fueled by a near manic real estate and banking bubble. And the credit markets are looking forward to the day in the not too distant future when Spain needs to sell more bonds and needs to cut its deficit and is voting, through the rising prices of credit default swaps, to lose credit worthiness every day.

There is another important element to the credit markets and the crisis. Credit default swaps are totally unregulated and are, as Warren Buffett described all derivatives, "financial weapons of mass destruction." A trader, a hedge fund, a whatever can put up ten cents or twenty cents and control a derivative priced at a dollar; these in turn affect the value of a bond one to maybe five hundred times greater in value than the derivative itself. You can do the math - someone playing with a dime can control the pricing of a thousand or maybe five thousand dollars worth of bonds. The same trader can put up a dime and control one hundred dollars worth of currency. Do the math - put up a dollar and ten cents and you can trade one thousand dollars worth of currency and control the value of at least a thousand dollars worth of bonds. You increase the cost of the derivatives, that in turn reduces the value of the bonds, and then you can make a super safe play on currency that moves as the bonds do. In this case, the euro. This is what happened to Bear, and Lehman and many other banks in 2007.

Governments are powerless to do anything. Derivatives are unregulated and are not traded on an exchange. You can thank former Republican Senator Phil Gramm and anti-government ideologues for this situation. And as they stand by and watch, the euro has fallen five percent against the dollar in the past month.

The Role of the ECB

The ECB is now caught between a rock and a hard place. It cannot bail out Greece, and if it arranges a quasi-bailout, it will cause a run on the euro because everyone will think it will bail out any wayward spending nation. It cannot print more money to take care of upcoming problems because its charter does not allow it to directly buy government bonds or provide direct support to a country. It cannot kick Greece out because this would be the beginning of the end of the common currency. And it cannot let Greece default as that would undermine the whole notion of a currency "union" and it would encourage short sellers and others to make raids on other member nation bonds and short the euro. And it cannot go to the lender of last resort - the IMF - because this too would undercut the role of the ECB and since Greece is locked into the value of the euro, an IMF loan would require government cuts and other changes that would trigger a massive recession and political unrest.

Current speculation is swirling around banks, coerced by their governments and the ECB, guaranteeing in some bank-to-bank fashion the purchase of Greek sovereign debt. This would technically avoid being a bailout. One problem is how to rate the debt. Moody's went public Wednesday and said if Greece does not make the necessary and drastic adjustments to its budget and deficit, its debt would be downgraded several notches and this would hit any banks, Greek or foreign, holding that debt.

This past weekend life was made more complicated when the G-7 group of economic superpowers said they will keep spending and stimulating as needed to prevent a further economic downturn - in direct contradiction to the ECB's call for more fiscal restraint in the future. I was surprised the G-8 did not soften its language. Then again, none of the four eurozone countries in trouble is a member of the G-7 and all have much greater leeway, other than Britain, to provide stimulus to head off any deepening of the economic crisis. But I sensed some anger at the ECB and eurozone community for letting things, budget-deficit wise, get out of hand. This attitude also limits Trichet's flexibility.

And, to highlight the political problems involved, a few days ago the Portuguese central government gave permission for its regional governments to spend more money - the opposite of what is needed to reduce deficits. The government there has also said it does not need help from outsiders. Yeah, right. Sounds like Dick Fuld a few days or even minutes before Lehman blew up.

Prognosis

So what will happen? For Europe, and the euro, rumors of a bailout have created some stability but nothing truly solid or good. A meeting of EU foreign ministers Thursday, long planned, will discuss the issue but German banks and others have said there is no immediate deal on the table and much depends on the actions of the Greek government.

At the national level, this is causing political unrest in all four countries and in Britain. Recent activity in the bond market indicates Britain may devalue the pound in the coming months in order to better manage its debt and the residual cost of its own bank bailout. Bill Gross of PIMCO is in this camp. This is also causing problems in larger, more stable countries such as France and Germany because the fall of the euro in value increases the cost of imports and creates inflation for consumers, consumers who vote.

My own view is more of the same - headlines containing promises, political paralysis and muddling through. Given the lead role of Goldman Sachs ( GS ) with the lead country, Greece, I can see sales of Greek bonds at very high real rates of interest to banks pushed and prodded by their own governments. Fifty three billion spread among banks in several countries is not a big deal, but after Greece, then what? If a deal is done for Greece, it will buy time and maybe head off more action in the derivatives market - and maybe not.

The Eurozone crisis has been brewing but has a ways to go before boiling over, which it will. The fundamental situation is not good. Governments borrowed money to keep people working or getting transfer payments or to bail out banks and companies and transferred liabilities from the private sector to the public sector. And now the public sector is being told you cannot borrow that much more.

The bottom line: As in the US, European lawmakers can change laws but they cannot change the laws of math. To bail out Greece - in whatever form, and then bail out Portugal and Spain - in whatever form, will require more euros; the ECB crating them, banks using them, sovereign debt being purchased, and the euro will fall. As this happens, bond markets will continue to downgrade the value of the sovereign debt of Greece, Spain, Portugal and Ireland, driven by fears about the nations' ability to service debt and by activity in the credit default swaps marketplace. And these nations will increasingly speak about deficit reduction plans and future plans to roll over and issue new debt. Goldman Sachs has agreed to sell Greek bonds - they hope and need to sell 53 billion in euro denominated bonds this year - but has yet to find a lead or principal buyer.

How to Short The Crisis

It is always high risk to trade with or against currencies and sovereign debt because of the risk of a political event or statement that drives headlines against you and ruins a position short term, making long term profits that much harder to achieve. That being said, the case against the euro is a strong one and the case saying US equities are being driven, in part, by the "dollar carry trade", which in turn is based on a falling dollar, is equally strong.

From low risk to high risk, here are ways to "short" the crisis:

Look at trend lines and where we have made money before - and that means US treasuries. Treasuries rise in value as interest rates fall - and interest rates fall as when there is flight to the dollar. To play Treasuries the ETF is the [[]TLT] and calls are available.

To buy the dollar itself , the ETF is [[UUP]]. Yes, calls are available.

The obvious play - more volatile but the underlying driver of all of this - is the euro. To short the euro you can look at puts on an ETF, the [[FXE]]. The highest risk trade is the put position on the euro. It also has the highest possible payoff if the run on the euro accelerates.

And remember, like Countrywide failing as a precursor to Bear, AIG, Lehman et al - Greece is only the beginning.

Disclosure: None.

I rarely plagiarize myself but the above was in part published in my service, ChangeWave Shorts. I have had so many questions about the crisis I felt this was an opportunity to explain in plain English some of what is going on across the pond.

See also 2 Short Ideas: MBIA and CETV on seekingalpha.com



The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of The NASDAQ OMX Group, Inc.



This article appears in: Investing , Stocks

Referenced Stocks: FXE , GS , HPQ , PG , TLT , UUP

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