Euro Is Still Short, By a Long Shot

by: Bo Peng

The Swiss central bank's dramatic intervention from 8-9am EST on 5/19, as widely rumored and as Telegraph reported an exodus of German deposits into Swiss banks, triggered a chain reaction of a short squeeze. There have been several massive bursts in EURUSD since then. The short squeeze has probably been exacerbated by a wide-scale, multi-asset liquidation later in the week. It was quite a breathtaking ride, either in exhilaration or pain, for those in the game. But the important question is, as always: what now?

It's a no-brainer for those who were on the right side and levered up. Enjoy your private island, good luck with BP oil, tsunamis, rising sea level etc. The rest of us have to go back to work.

My guess is, since EURCHF is back above the pre-Greek-crisis managed level of 1.347, the Swiss central bank will likely rest for a while. The Yen rise has retreated back from the USDJPY 90 level. So BoJ shouldn't be in panic mode any more. I can imagine why the ECB would want to slow down the EUR plunge, but they have every reason to be secretly happy with a controlled descent. The Fed may not like the dollar's stubborn strength, but direct intervention in FX markets is so below them. They have a number of more subtle, more "free market" tools available before resorting to such a barbaric measure. Overall, the risk of central bank intervention has significantly decreased after last week's shocks.

But never mind central banks. Their intervention only has short-term effects. If your time scale is more than a few days (and you survive a few possible margin calls in the process), you're better advised to write them off as noise and focus instead on the bigger fundamental picture.

1. The Euro crisis is far from over, and a weak EUR is their best hope.

The causes for the current eurozone crisis include chronic weak productivity and lack of fiscal discipline (more so in PIIGS but nobody is clean), loss of control over monetary policy for member countries, structural imbalance in some deeply rooted socioeconomic fundamentals among member countries, and a lack of political union to support the monetary union. None of these causes is any closer to being resolved now than a month ago.

Sure, austerity measures announced by PIIGS are impressive. Even France (gasp) has its own. Now you know why France has been on the opposite side of Germany on everything throughout the crisis -- it really should be FIIGS because Portugal is not big enough to cause much trouble. This is definitely the right thing to do. But first, there's still huge uncertainty on how much of the announced measures will carry through, with the riots and all. Secondly, even if they are carried through, they will most likely cause more pain, in the form of lower GDP and even higher debt/deficit, for a few years before they bear fruit. Either way, a double-dip in the eurozone is almost a certainty.

The latest signals from Europe is that the elites want to use this opportunity to push for a political union, though each with a different agenda. Let's face it, they've been ogling the US federal-state model for ages, trying to be discreet but quite conspicuous to a bystander. I wish them success. I think it's in principle doable and would be a great thing for the world at large. But this would be an enormous undertaking, taking at least years and with huge changes, inevitable chaos, and significant risks along the way. But back to the topic, a surging EUR is not one of the risks in this scenario at least until its fruition.

2. Greece=Bear, Spain=Lehman

If Greece took the EU/ECB so much time and effort to come up with a duct-tape solution, wait until you see Spain.

Here's a quarterly GDP graph of the eurozone big four based on data from their respective stat bureaus (10Q1 is preliminary):

click to enlarge

Two things about Spain stand out:

1) Their recovery trend has been the slowest and lowest.
2) There must be something amazing about the Spanish economy. It's so smooth it looks almost unnatural. Of course, there can't possibly be any manipulation or hidden surprises such as in Greece. Must be my imagination.

Back in 08, the US gov (and many people) thought Bear Stearns was just a liquidity problem caused by evil speculators. They fixed it accordingly. But the evil speculators saw that the real problem was solvency. A few months later Lehman (OTC:LEHMQ) popped up and they couldn't whack this mole with their liquidity hammer fast enough. Over the course of a few months the bank insolvency problem was transferred to tax payers. The storm has quieted down for now. But if you think it's all gone, look at bank lending, Fannie Mae (FNM), Freddie Mac (FRE), and how nobody in the government even wants to talk about them.

I see a perfect historical rhyme being created in the eurozone.

With the rapid rise in financing costs (both public and private) and non-stop regulatory confusion across Europe, UK included, as well as the risk of another round of worldwide demand contraction (China cool-down and US stimulus winding down), I don't see how the eurozone outlook for this quarter and the next few could continue the recent uptrend.

The next trigger, however, will probably not be in the form of sovereign debt. That's temporarily backstopped by the EU package. Instead, the private sector, especially financials, will surface as the problem next. Even if European banks offload all their FIIGS' sovereign debt to the ECB, either through outright selling or as collateral, there's no escaping from the persistent high financing costs, the other bad assets on their balance sheet, still high leverage, and a slumping economy. Here, Spanish banks are arguably among the worst in the eurozone due to their high exposure to real estate and gloomier-than-average domestic economy.

3. UK is not helping, either.

The cancerous outgrowth of the financial sector is almost as bad in Europe as in the US, but at least as bad in the UK. UK public debt/deficit problem is increasingly hard to ignore. Libor is once again, after late 08, only relevant to European banks. When eurozone banks get hit in the coming months/quarters, UK banks will be in a perfect synchrony of slumping.

And here lies the rub for the US. So far Geithner has been assuring Congress and Beijing that US is decoupled from the eurozone turmoil, much like how the ECB raised rates in 7/08. But when eurozone banks get hit, and especially when UK banks join the party, the decoupling pipe dream will once again get a rude awakening.

But that's a later problem to worry about. For now, hang on to your EUR short and enjoy the ride. Just watch out for quick squeezes if it plunges too fast.

Disclosure: None