Ireland plays the default card, possible PIIGS revolt, why the EUR keeps rallying anyway, and ramifications for spot market and binary options traders:
On the surface, things look great for the EU and the Euro.
Note how on the weekly charts below, the EUR was up again this past week vs. all major currencies except for the CHF. Click to enlarge:
EUR WEEKLY CHARTS VS. (CLOCKWISE) THE USD, JPY, GBP, AND CHF COURTESY OF ANYOPTION.COM 01MAR 200514
EUR WEEKLY CHARTS VS. (Right to Left) the AUD, NZD, and CAD COURTESY OF ANYOPTION.COM 02mar20 0516
The ongoing rally in the Euro is remarkable considering that there is no immediately apparent fundamental justification for it.
What Drives The Euro?
Logically, the EUR requires one or more of the following fundamentals to improve in order to rally.
- Rising risk appetite as reflected in rising global stock indexes
- Improving expectations of interest rate hikes
- Rising confidence that the EU sovereign debt and banking crisis will not worsen
Yet none of these are in place!
- Rising risk appetite as reflected in rising global stock indexes: Not present, as stocks continued down this past week and have been in an overall downtrend for the past 4 weeks. With no less than 3 ongoing major crises (each of which was by itself enough to flatten markets in past weeks) ongoing and risk assets still far from cheap, odds do not favor a near term reversal higher
- Improving expectations of interest rate hikes: No, mostly priced in already, though Trichet’s repeating his hawkish stance this week gave the Euro some support after the Japan and MENA crisis led many to wonder if the ECB might delay its planned rate hikes.
- Rising confidence that the EU sovereign debt and banking crisis will not worsen: While markets looked favorably on the decidedly unimpressive steps taken at the last summit, there’s no reason for rising confidence when we look at the actual facts themselves, which paint a worsening picture for the EU.
Let’s look deeper at the deterioration in the EU sovereign debt and banking crisis.
Key EU Crisis Review: It’s A Banking Crisis Most Of All
While many refer to it as the EU sovereign debt crisis, we prefer to call it the EU sovereign debt AND banking crisis. Why? Because a sovereign default and suffering it might cause for its people is not really the key concern for the Eurocrats Brussels, Luxembourg, and their real bosses in Berlin and Paris. Certainly the EU has not been shy about imposing deep suffering on PIIGS citizens via austerity programs.
Rather what really worries the EU officials and funding nations is the solvency of the leading EU banks – which would be severely compromised in the event of a PIIGS default because these banks hold most of these dubious PIIGS sovereign bonds.
If one PIIGS nation defaults, none of the others will be able to access credit market as borrowing costs for all will soar out of range.
That means one default is likely to cause many more.
That means a loss of confidence in the EU banking system and its collapse without a massive bank bailout program, which would be harder to do than it was for the US given the number of governments involved. It’s this fear that has literally ‘frightened the Euros’ out of the funding nations (and the US via the IMF) that were needed to fill the bailout fund thus far.
The mere uncertainty about which banks MIGHT be rendered insolvent was enough to halt interbank lending and crash markets in the spring of 2010 as Greece teetered close to default while the EU dithered over who would bear the cost of a bailout. That fear quickly crashed markets worldwide on fear of contagion, which made sense given that just the fall of Lehman brothers alone had crashed markets back in 2008, so why wouldn’t a wave of sovereign and major bank defaults be much worse?
Once you understand that the EU crisis is at least as much a banking crisis, the potentially revolutionary threat Ireland presented this week becomes clear.
Ireland Goes For the Jugular: May Start PIIGS Uprising
Elected on a promise to negotiate a better bailout deal, the new Irish PM is under intense pressure to produce results. However thus far, Ireland’s justifiable demand that it’s mere 4 million citizen’s not bear the sole burden for the errors of Irish, German UK banks has been mostly ignored, or met with niggardly offers on the condition that Ireland give up its best hope for recovery – its low corporate tax rate that helps it attract foreign investment.
In response, Ireland has cut off funding to its insolvent banks until it gets a better bailout deal that includes having the bank’s bondholders bear take a partial loss and thus share the burden of recapitalizing these banks.
This means Irish banks are due to default on their next bond payments, which are owed mostly to German and UK banks.
That would shake confidence in these banks and risk at minimum their needing bailouts. If these aren’t promptly supplied, we risk uncertainty about German and UK banks in general, which could quickly metastasize into uncertainty about who is exposed to these banks, which then leads to doubts about EU banking and risks a repeat of the spring of 2010.
That it’s none other than Germany itself which finds itself most exposed to Ireland gives PM Enda Kenny additional leverage, and he’s using it to ask for new concessions. For more on Germany’s vulnerability to Irish bank defaults, see here.
Of course, any concessions to Ireland will also be demanded by Greece, and, when the time comes (expected to be a matter of weeks at most), Portugal too.
Portugal’s Special Leverage: Spanish Vulnerability
Perhaps what allows Ireland make this threat now is that it’s got a potentially potent ally in Portugal, because Portugal’s stability is key to avoiding ‘the big one,’ a spike in Spanish bond yields that shuts them out of credit markets and risks a default too big for the EU to afford to bailout without massive funding and money printing.
Portugal suffers from a toxic combination of low cash and a divided parliament that threatens to bring down the current coalition. It is expected to need a bailout within a matter of weeks at most. Yet it too has leverage. Its biggest creditor is the Spanish banking system, aka the one with so much bad debt that it’s too big to bail out with the current bailout fund.
It’s uncertain whether the Spanish banking system could handle a Portuguese default. Again, however, uncertainty is all that’s needed to shake confidence, cut off interbank lending to Spain, send its borrowing costs beyond what it can afford, and thus ignite a genuine risk of Spain needing the very bailout the EU can’t afford, at least without some form of expanded bailout fund or money printing.
Naturally, Spain is aware of these risks, and may thus urge greater generosity towards Portugal and Ireland.
EU Facing Rebellion AND Earthquake?
There’s an old saying that goes roughly as follows: If you owe the bank $1 million and can’t pay you have a problem. However if you owe the banks $ 1 billion dollars, the bank has a problem.
Ironically, as the EU has fed the PIIGS more debt, it may have created the conditions for the very crisis it sought to avoid in the first place via the bailouts.
Could Ireland’s threat be the start of a PIGS rebellion that starts a restructure (partial default) of debt from Ireland, Portugal, and Greece? Would this financial quake shake EU banking unless a massive bank bailout comes too? That’s what we’ve suspected for some time. See here and here for details.
In sum, without even considering who Greece owes, we may have the start of the biggest PIGS (leave Italy aside for now) uprising since Orwell’s Animal Farm.
There’s More EU Trouble
Other rather disturbing developments in the EU include:
- Growing evidence that the coming EU bank stress tests will once again be more of an exercise in propaganda than fiscal probity. See here for details.
- There’s growing German domestic opposition to payments for an expanded bailout fund. There are many examples of this , perhaps most noteworthy is this past week’s German Parliament passage of a motion to prevent the EZ’s rescue fund from buying PIIGS bonds. Angela Merkel had just recently agreed to that. While the motion is not binding, it is worrisome because this same body must approve any actual German disbursements to the EFSF bailout fund. See here for details.
So Why Is The EUR Rallying?
Despite the above problems, the EUR is rallying. Moreover, both Spanish and Portuguese bond yields have been falling, suggesting greater confidence in these bonds.
Portugal is the easiest to explain – it’s expected to get a bailout that pushes off the ultimate day of reckoning regardless of its political situation. Spain’s vulnerability to a Portuguese default insures that.
Thus confidence in a Portuguese bailout eases concern over Spanish bonds, at least in the short term.
Still, these are not enough to justify the EUR’s continued rally to new highs given that NONE of the three usual fundamental drivers of a EUR rally is present.
So Why IS The Euro Rallying?
One possible reason, the best one I’ve heard, (via dailyfx’s Joel Kruger) is that there are some very large players like sovereign wealth funds or central banks that have made an understandable decision to diversify out of the USD, given the Fed’s clear willingness to sacrifice the USD’s value for the sake of stimulating growth. The most liquid alternative is the EUR, so these big buyers come in on dips – bringing technical traders with them, regardless of fundamentals.
Of course, that buying will last only as long as these buyers believe the EUR is at least as good a store of value as the US dollar. Is it?
For at least the second time this week, I’ll draw from from Chapter 10 of Mauldin & Tepper’s new masterpiece, Endgame, in which they recall Nobel prize winner economist Robert Mundell’s criteria for an optimal currency union:
…a currency area is optimal when it has:
- Mobility of capital and labor
- Flexibility of wages and prices
- Similar business cycles
- Fiscal transfers to cushion the blows of recession to any region
Europe has almost none of these. Very bluntly, that means it is not a good currency area.
They then go on to show that the US is a good currency union in all respects.
Admittedly, the EU has a much better attitude about attempting to maintain the value of its currency, and that, perhaps, has made all the difference.
Ramifications For Traders & Investors – What To Do?
So what does this mean you should do?
Background: Is This Friday’s EU Summit The Day Of Reckoning?
It’s supposed to be the meeting that defers PIIGS defaults and thus the EU debt & banking crisis for the foreseeable future (no one is expecting a permanent solution because there is none at this time).
However we appear to be still firmly in the middle of stage 5 of the 7 Stages of the EU Panic Cycle.
In stage 5:
- Everyone knows a default or bailout is coming soon and it’s time to decide how to distribute the pain – who will fund it, and how much pain the ‘beneficiary’ must take in order to get the cash.
- However leaders of both sides need to play to their voters. Neither will make real concessions until we hit stage 6, in which markets are crashing and there is clearly no choice but for everyone to bend over and take one for the good of the EU, or risk catastrophe for all.
We aren’t at the crisis stage yet, so expect more of the non-solutions we saw at the last EU summit, which was short on funding details and ignored the two immediate threats, Portugal and Ireland.
Expect more of the same unless markets are crashing on concern about a default, be it on bonds from Irish banks, Portugal, or somewhere else. Any one default is feared to be enough to panic credit markets and send the PIIGS reeling towards default unless the EU does exactly what all those EUR buyer have assumed the EU wouldn’t do: print money and devalue the currency on a magnitude similar to that of the US Federal Reserve.
Implied Strategy
Thus even as the Euro continues to show technical strength, we suggest you get ready to short the Euro, using any vehicle you choose, once the downtrend gets going. For those not familiar with the numerous trend trading techniques, see HOW TO TRADE TRENDS: A SIMPLE SHORT TERM NEWS TRADING STRATEGY for a simple starting point. It introduces just two simple indicators that are available on free charting sites like Yahoo Finance’s free charts.
- Forex traders: short the EURUSD, EURCHF, or other pairs depending on the variety of factors that influence which pair is most promising. The JPY has also shown strength recently, but events in Japan and the G7 intervention over the past week make us uncomfortable recommending being long the Yen versus almost anything in the near future.
- Stock traders: To play the EUR drop, buy the short EUR ETF EUO, short the long Euro FXE, or go long the USD ETF UUP, because the USD tends to move opposite the Euro.
- Binary Option Traders: Once you believe the EUR is pulling back, buy puts on the EURUSD, EURCHF and other pairs depending on circumstances at the time. Note that this trend may yet take some time to evolve so consider sticking to longer term weekly or monthly puts. I believe both anyoption.com and extrader.com offer weekly expirations, and I know anyoption.com also offers monthly expirations. There may be others as broker are adding products constantly and new brokers are offering binary options to the retail trader.
Once the trend gets moving, and ONLY then, you can focus on shorter daily or hourly expirations.
For those not familiar with binary options, just know for now that they are in many ways ideal instruments for trading trends given their less complicated risk management issues, more tightly controlled risk, and high profit potential similar to that of highly leveraged spot forex trading. I hope to get to a full article on the pros and cons of binary options so you’ll be able to just refer it in the future as a reference source.
NB: If The EUR Drops As Part of Renewed EU Crisis Fears
In case we do hit the crisis stage, stage 6 of the 7 Stages of the EU Panic Cycle, then we have a full blown ‘risk off’ event and expect most risk assets like the S&P 500, other global stock indexes, risk currencies and industrial commodities to sell off, so be ready to short them. Binary options traders buy puts on them.
Conversely, in that case be long the USD. The JPY could be an option too IF the carry trade unwinding hasn’t already finished. Be wary of the CHF, which sold off during the last EU crisis because the EU is the prime export market for the Swiss.
DISCLOSURE & DISCLAIMER: AUTHOR SHORT EUR, NO OTHER POSITIONS, 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
