Tuesday saw the EU's Jean-Claude Juncker strike down the potential for a total restructuring of Greek debt and note that further aid to Greece would be negotiated by the end of June. With this statement, it became clear that interested parties in Greece and the troubled PIIGS would pursue the bailout route rather than debt restructuring. Or at least that is the precedent that is being set.
In a recent article I noted that there were essentially two long-term solutions for Greece: (1) restructuring of domestic debt to a manageable level or (2) that the IMF, ECB and EU, either piecemeal or through a coordinated effort, bail out private debtholders to the point of eliminating rating agency concerns for Greek solvency and allowing Greece to re-enter credit markets. While there is still the possibility of an additional "soft" restructuring by way of a voluntary term extension on privately held Greek bonds, Juncker's words marked the continued move down the path of a complete bailout.
So now that the path has been rather clearly set, how should traders and investors be treating this market? I will note a few possible angles to take.
1. Short Euro, Long Dollar or Gold/Silver
This is a trade that will likely realize its value after the focus shifts from Greece to the next PIIGS country to migrate to the brink. After the Greek bailout is eventually completed, politcal will will have been sapped, as the bickering between bailed out nations and those doing the financing hits a fever pitch. This, combined with the final cost of a Greek bailout, may leave a political environment hostile to another bailout and tired of the common currency altogether.
As investors start to reassess the total cost of a complete bailout of troubled PIIGS members, expect further selloffs in euro-denominated assets and further migration to safer assets and the dollar.
I believe that the major trade here centers around the euro/dollar relationship, but I added in precious metals for those not wishing to assume dollar exposure (although precious metals might not fare any better).
2. Long Greek Debt or Treasuries and Short Irish, Portuguese, Spanish and Italian Debt
As mentioned above, the appetite for another bailout will diminish rapidly with each successive one; in light of this, I strongly believe that in the event of severe distress, interested parties of the international community will act much less favorably towards future bailout recipients than they are acting currently with Greece. This is to say, as a thank you for being the first to almost collapse, Greek bondholders will likely receive much better aid than subsequent PIIGS countries.
I would not be shocked if the next country to need help either exits the euro zone or engages in some form of debt restructuring. If not the next country, then the one after that. Similar to how Bear Stearns fared better than Lehman Brothers by being the first to fail, so too will happen with Greece relative to other PIIGS in need of aid.
The Greek end of this trade would not be for the faint of heart, and in light of this I added Treasuries as the less-risky long to take here. In the long Greek scenario, the trade is based on a default mispricing of Greece relative to other PIIGS for the reasons stated above. For the long Treasury scenario, the trade centers around derisking and migration away from the euro following subsequent bailouts.
3. Long Treasuries, Short American Financials
This is counterintuitive to an extent, but centers around two theses:
- The short European financials trade is currently or will soon be crowded.
- The international financial system is incredibly interconnected.
This is to say, even if an American financial is not directly exposed to PIIGS debt, it has a counterparty somewhere that is. I would expect this trade to pay off the most when the next country after Greece needs aid, since this is where necessity will likely begin to push for a restructuring over a bailout, which may register as a credit event. If not, the derisking trade following the need for further intervention in the euro zone will likely punish still fumbling financials.