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