Will A Greek Default Spark The Next EUR Plunge?
As I discussed in my recent post, 7 Stages of the EU Panic Cycle: Understanding and Profiting, we are currently in Stage 5 (relative) Calm of the latest round of the EPC, which officially began with the Irish stage of the EU sovereign debt and banking crisis. See the post for an explanation of these stages.
Stage 5 Calm is characterized by fluctuating sentiment about the latest EU trouble spots, which are currently:
- Ireland: Will elections bring pro-default government? For a full discussion see John Mauldin’s great piece here.
- Portugal: When will it need a bailout? There are unconfirmed reports that France and Germany want an early bailout for the same reason they wanted one for Ireland. It will come anyway, so they might as well avoid risking a crisis and undermining market confidence in the EU.
- Spain: It’s not in immediate trouble, but if its bond rates stay high into 2011 when its next big bond sales come, it may not be able to sell enough bonds to pay off maturing debts. Unlike Greece, Ireland, and Portugal, Spain’s debt is too large for the current bailout fund to cover. Thus, Spain has been widely considered THE big concern.
In Stage 5 Calm, markets (especially bond and forex; other markets like stocks may feel less influence) swing from optimism to pessimism with the latest news, which is rarely decisive but colors sentiment. These swings are most visible in bond and forex markets, and less so in commodities and stocks, which are somewhat less sensitive to the EU crisis for a variety of reasons. Typical examples of such news includes:
- The bullish: Some kind of verbal support for bailouts from the EU or other major economic power that lack both details and firm funding commitments. Still, it boosts optimism and maybe the EUR, especially if the EUR has been oversold in the past days and is ripe for an excuse to bounce. Examples include recent Japanese and Chinese expressions of support and vows to buy PIIGS bonds. They have many reasons to want a stable EU. It’s a key export market, and a stronger EUR means a weaker USD, which helps keep the USD-pegged Chinese Yuan low and Chinese exports cheaper.
- The bearish: Spiking PIIGS bond rates, especially as large bond sales approach, or threats by leaders of debtor nations to accept further draconian spending cuts or losses of budget control, or from leaders of funding nations to refuse to commit more funds. A recent example would be German Finance Minister Wolfgang Schauble’s opposition to expanding the EFSF, EU’s bailout fund, which will need a massive infusion of cash if the EU is to have any hope of convincing markets that the EU can backstop Spain.
As noted in Part I, the current Stage 5 Calm is a waiting period in which the EU crisis exerts less influence with the up and down days canceling each other out over time, and thus exerting little influence on market trends, at least compared to the panic or euphoria we see in some of the other stages discussed in Part I.
Thus, trading in the EUR or related bonds is best avoided at this stage by all but the short term traders, while the longer term traders/investors watch for the catalyst that brings Stage 6 Fear or Panic.
Will Greece Be The Catalyst For Stage 6 Panic?
On Wednesday, we may have seen a potential catalyst from a fitting source, Greece, where the EPC was officially born.
- Reuters reports here that German officials are preparing for a Greek restructure (aka, partial default)
- Adding to the tension, in his Reuters blog here, Felix Salmon summarizes the growing chorus of influential opinion that a number of the weaker EU economies will ultimately need to restructure in order to have any chance of avoiding total default
None of this is really news, as credit markets have long assumed a Greek restructuring within the coming 3 years. Of course, once one nation pulls that off it makes similar moves easier for others, or may even force the others to restructure or default as confidence in EU sovereign debt plunges, similar to what has happened to Latin American government bonds during past defaults from that region.
However, even though the news isn’t new, predicting when these concerns start to roil markets is difficult because these are ultimately political decisions, beyond the usual fundamental or technical tools that traders use.
Greece is the likely first restructure, though it’s possible that EU officials will anticipate market panic and try to announce a coordinated, larger scale restructuring for multiple countries AND a believable mechanism to ensure that the banks absorbing the losses remain stable.
US Q4 Earnings Bullish Thus Far, Keeping Markets Aloft
So only longer term investors should be considering EUR shorts at the moment, though we always advise waiting until we get some reversal, and not trying to outguess the markets.
Note that while we remain in Stage 5, markets are more influenced by other market drivers, and we have a strong one on the scene now, US Q4 2010 earnings season. It is in its second week, which is typically when it has the most influence on markets because it is still setting its overall bullish or bearish tone. In another week that will be clearer, the news will already be priced in, and earnings season will rapidly lose influence.
With results thus far quite bullish, risk assets, including the EUR, should get a near term boost. Thus, the EUR rally may have some room yet, and could well test its November highs around the 1.3600-1.3700 zone in the near term. Possibly up to 1.4000 if calm is maintained in the EU as we head into the light economic calendar weeks toward the end of January, giving markets a chance to continue to drift higher on the sheer momentum of the current uptrend.
Guidelines For How To Profit Or Avoid Loss
As we noted in Part I:
- The time to get long on risk assets, especially the EUR, is when a panic stage is winding down, as shown by a flattening out of the EURUSD or EURJPY after a plunge. Ideally, we wait for an uptrend to begin and commit to the move up when we get some kind of technical confirmation.
- The time to get short on risk assets, especially the EUR, is after the EUR has had a multi-week/month rally, markets are relatively calm about the EUR, and we see that the EURUSD or EURJPY uptrend start to flatten out. At that point, one can start putting in small short positions when we see major resistance zones holding up, and add to them as news becomes more negative (spiking PIIGS bond yields, etc) and/or the EUR begins to downtrend.
We have long believed that the long term EUR trend is lower, so those with a long term approach can consider new shorts. Note that when the EUR is really plunging it suggests deep fear about the EU, and thus, chances are excellent that most markets will be in serious retreat and ripe for profit taking on short positions as that retreat slows.
Disclosure: Author is short the EUR, long the CAD, AUD and USD. He is long selected equities held as long term income/growth investments. Short the overall stock market for his personal portfolio. The above is for informational purposes only and not to be construed as specific trading advice. Responsibility for trade decisions is solely with the reader.
