Europe Game Over

The New Your Times published a very interesting chart the other day which outlines how deeply in debt the PIIGS (Portugal, Italy, Ireland, Greece and Spain) are: $3.889 trillion or 4.958 trillion euros at Friday's exchange rate. Of that amount, $2.053 trillion or 2.617 trillion euros, is owed to Germany, France and Britain (or presumably, their commercial banks).

Meanwhile, the absurdity of the Greek "rescue" package will only serve to put the nation further into debt both in absolute terms and in percentage terms of its GDP. As of 2009, Greece's GDP was about $345 billion, which means its debt-to-GDP percentage was 68.4%. But with $136 billion of new debt (the EU-IMF rescue package) and with Greek GDP estimated to fall about 4% in 2010, the percentage of debt-to-GDP rises to over 112%.

In other words what we have here is round 2 of the debt crisis, which is defined as "which banks are exposed and by how much." Round 1, as you're probably aware of, occurred in September 2008 after Lehman Bros. was allowed to collapse. At that time, as now, no one knew exactly which banks were exposed or by how much (although it was generally known that the exposure was huge). As a result of the uncertainty, inter-bank lending rates (LIBOR) soared as banks refused to lend to each other, which naturally caused financial markets to freeze.

We're already seeing the beginnings of this same scenario happen right now. On Friday, 3 month LIBOR (the cost of borrowing dollars for 3 months) climbed 5.5 basis points to 0.428%, the highest level since Aug. 17, 2009 and the biggest increase since Jan. 16, 2009. It also was the 13th straight gain in this "fear gauge."

The spread between three-month Libor and the overnight indexed swap rate rose more than 6 basis points to 18.5 basis points, the most since Aug. 26 2009. The measure at one point ballooned to 364 basis points, or 3.64 percentage points, after the Lehman debacle.

According to Simon Johnson, former chief economist at the IMF and co-author of the new book 13 Bankers, the joint EU-IMF program has only a “small chance of preventing an eventual Greek bankruptcy.”

During the negotiations which occurred prior to the announcement of the Greek plan, The IMF floated an alternative scenario with a debt restructuring, but this was rejected by both the European Union and the Greek authorities. This is not a surprise; leading European policy makers are completely unprepared for broader problems that would follow a Greek “restructuring,” because markets would immediately mark down the debt (i.e. increase the yields) for Portugal, Spain, Ireland and even Italy.

The fear and panic in the face of this would be unparalleled: When the Greeks pay only 50% on the face value of their debt, what should investors expect from the Portuguese and Spanish? It all becomes arbitrary, including which countries are dragged down. Adding to the problems are that European structures are completely unsuited to this kind of tough decision-making under pressure.

So, where do you go as a trader? Certainly, in the face of what’s happening you want to be out of anything that looks risky, which means stocks and commodities. The dollar is likely to continue gaining in this situation because there’s no other paper currency which can serve as an alternative. But there is one other “currency” however: Gold.

In “normal” times, gold trends downward as the dollar gains and it rises when the dollar falls, which is what happened once the dollar began depreciating as stocks rose from Mar. 09 2009. But when panic sets in, as it did after Lehman collapsed on Sept. 15, 2008, gold appreciates along with the dollar. For example, from that day until stocks begin rising, gold went from $779 to $929 while EUR/USD went from 1.4242 to 1.2889.

Gold and the euro peaked in early December as traders first began speculating on European problems. But once the market started to better appreciate the full extent of the European debt crisis in early February, gold rose from a low of $1044 to reach $1207 even as EUR/USD fell from 1.3677 to Friday’s close on 1.2750.

I would look for this trend to continue, because what’s going to happen is either one of two things: Debt restructuring or the far more likely debt monetization by the ECB, which means that Europe’s Central bank will be printing a lot more euros in order to buy the debt of the PIIGS.