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Action in Europe is becoming interesting. A whole bunch of countries have trouble financing their budget deficits, with Greece and Spain having the most trouble. Half a year ago, Hungary and Latvia had similar problems, but they managed to get loans and can breathe (for now). In the near future, we might also witness panic regarding Portugal and Italy, and maybe even the UK.

There are two big unknowns in this situation. First unknown: will the EU bail out every country nearing default? Or will they decide to play strict parents and let one of the countries default. I am almost sure that there will be at most one default in EU (one of my non-predictions for 2010). But honestly, even one default will be too many.

The second unknown is even bigger. There are hundreds of billions of dollars in dollar carry trades. A portion of those dollars were borrowed to make loans and buy debts denominated in euros, playing on the difference of interest rates and on the idea that the dollar has nowhere to go but down (remember, everybody was saying exactly that just three months ago).

The bigger question now: at what exchange rate do most of the carry trade players set their stops? Because if a carry trade unwinds, even its part which is related to euro, it might get ugly.

I'm watching the action with mixed feelings. There is a big temptation to buy stock in Greek and Spanish companies, which are selling well below book value now. But in case of default and/or carry trades unwinding, they will be selling at an even bigger discount to current prices. And, in that case, it's a question as to which of those companies will survive.

For now, I am going just to watch.

Disclosure: No positions

Source: Defaults in EU: Zero or One?