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.

CBs to the Recue

I made the following predictions back in December. Things have evolved in ways such that I am close to being completely right or completely wrong on both of them.

-The Federal Reserve will become active in the foreign exchange markets. At different times of the year they will both buy and sell dollars. Their objective will be stability. These efforts will be referred to as “smoothing operations”.


-There will be no breakup of the Euro. Greece will not pull out. The strong members will provide some relief for the weak. But the problems will not go away and the possibility of some form of two-tiered Euro will be a matter of open discussion. It is in this context that the Fed’s FX intervention takes place.


In my opinion the decline of the Euro in 2010 has be orderly, up to the last week. Two "big figures" on any given day is part of the adjustment process that is necessary due to the changing fundamentals. That is not disorderly. But we have lost five big figures in a week. That is a big adjustment, but is still not the Central Banker's definition of a market that would necessitate coordinated intervention. But it is getting close. A few more days at the current pace would likely get us to the point where some action may be required.

The problem is that the Euro/$ is the "go to" trade that reacts to every bit of bad news that is coming out of the EU. I am not sure if the Euro is falling because Spanish bonds are in the crapper or if Spanish bonds are getting hit because the Euro is so weak. If the deep thinkers at the EU central bank are in the later camp then they must be itching to react. Everything they have built for the past 20 years is coming unglued. They are unlikely to go down easy.

I dismiss the news/rumor/importance of the BIS being in the market. If something is going to come it will arrive with a bang and it will not be subject to any guesses. There will be clear statements by the ECB that they have, “Acted decisively to stabilize markets”. They will sell 10-30 billion dollars into the market over a few days. That is not that big an amount in the FX markets, but it will have the effect of re-establishing the notion of “two way risk”. It has been far too easy to make money shorting the Euro. They need to change that risk/reward equation.

This possible action could take a number of forms. Should it happen it would look like one of the following:

A) The EU Central Bank draws down swap lines at the Fed and sells dollars for its own account. This is the “Go it alone” approach. It will not work. It will look like a weak effort that does not have the support of the other central banks. It will fail in short order.

B) The ECB and the Swiss National Bank would intervene jointly. The Swiss would buy Euros and sell the CHF. (They love to do that, but have been bashed by the market in the past). While this approach would be better than A, it would not get the job done.

C) The Bank of England joins in with the ECB and the Swiss. This would be a hell of a party, and probably would reestablish a two-way market. But I don’t think it will happen. There is too much election pressure for the BOE to get involved, unless:

D) The Fed joins the festivities. That would be decisive, and with the US cover the Brits would get in the game.

A and B will end badly, C will not happen. Only D has a chance of buying two to three months to address some of the problems. At best this means by the end of the summer we will be back at it.

It is equally possible that the global CBs will do nothing and the Euro makes a beeline to 1.10. That approach will end badly as well. My prognostications will not come true. If the Euro was to collapse, Greece would be forced out of the Euro Zone, and it would be followed in short order by a sharp decline in economic activity for 500mm people.

I made another prediction back in December. If A, B or the “Do Nothing” plan are in the future, then I think this one will come home:

Taken from Bruce Krasting