In recent days and weeks, I have been observed a number of factors that are leading me to believe we are heading rapidly into a double dip recession. From an emotional standpoint, it feels eerily similar to the spring of 2008. It seems as if the writing is already on the wall, but investors are simply choosing to ignore it and hope for the best. The key difference this time around, I believe, is that the epicenter of the crisis will be Europe, rather than the United States. However, as we learned just three years ago, a financial crisis anywhere in the world quickly affects the entire world.
There are a number of factors both domestically and abroad that are causing me great concern. For simplicity's sake, I will try to discuss each individually first. Afterwards, I will explain what I think this means more broadly and how I think investors should position themselves. Let’s begin with the elephant in the room that will likely serve as the catalyst for the financial crisis’ second at, Greece.
Investors are more fortunate this time around, as the problems with Greece are far more transparent than the problems with Bear Stearns, Lehman Brothers, et al. Let’s start with some public data that illustrates the severity of the situation. Greece’s level of debt as a percentage of GDP is close to 150%. The yield on a Greek two-year note is around 26%, similar to that of a high-interest rate credit card. Greece’s sovereign credit rating is firmly in junk territory, reaffirmed by Moody’s rate cut this week following S&P’s last year. At this point it is abundantly clear that Greece’s situation unsustainable and a default is inevitable.
Unfortunately, that conclusion is really just the beginning of the problem. Last year Greece was extended a $147 billion rescue package in exchange for drastic austerity measures. Greece has failed to hit key metrics stipulated in the rescue package and is again in need of capital to service its debt.
This is where the problem begins to get more complicated. Over 70% of last year’s rescue package was funds provided by other euro zone countries, primarily Germany and France. It is very unlikely that fiscally responsible countries like Germany and France will continue to front capital for Greece’s interest payments. However, they are continuing to do so because they know the other option is even worse. I believe that a Greek default is inevitable, but we will discuss the rationale for prolonging the inevitable in a moment.
For now, let’s analyze the hypothetical situation of a Greek default and draw on lessons learned during the first leg of the financial crisis in 2008. If Greece were to default on its debt and leave the euro, it would result in massive write-downs for holders of Greek debt, namely the ECB and major banks. The Wall Street Journal estimates that write-downs would range from 40-60% (article) and Sean Egan of Egan-Jones Ratings believes it could be as high as 80%.
Another issue would be credit default swaps issued on Greek debt. What banks have been issuing these and who is most exposed? Likely candidates would be major European banks like Deutsche Bank and Societe Generale. (I have been unable to unearth data on specific bank exposure.)
Across the pond it seems as if we are finding ourselves in a situation similar to 2008 – emergency weekend meetings to negotiate rescue packages, potential write-downs, and the very large possibility of contagion in the financial market. And, much like 2008, contagion will be of utmost concern. It is for this reason, I believe, that the ECB and IMF are prolonging the inevitable Greek default. The credit rating agencies have already warned that a Greek default could trigger further downgrades for other periphery nations like Ireland and Portugal. Further downgrades would increase their cost of capital and increase the need for further intervention. The WSJ makes a very salient point that if other nations find their credit rating reduced to junk status as well, it may trigger selling by money managers mandated to hold investment-grade securities.
Perhaps the largest reason for postponing the Greek default, though, is to allow more time for other financially strapped nations like Ireland, Portugal, Spain and Italy to shore up their financial situations. By prolonging the inevitable, the ECB and IMF are buying time to “sandbag” larger nations and institutions, in the hopes of minimizing damage once the domino effect begins. This actually seems to make some sense, but given the cost it will likely be a short-lived strategy. The people of Germany and France will only subsidize less fiscally responsible nations for so long. There simply isn’t the political will to continue paying interest on Greece’s debt.
Back in 2008, the canary in the coalmine was the increase in LIBOR starting in 2004. A similar metric knows as Euribor, measures interbank lending denominated in Euros. Since the sovereign debt crisis in Europe emerged last year, there has been a noticeable increase in Euribor rates. While this is a little unsettling, there is a caveat. Given the recent ECB rate hike in April, the subsequent uptick in Euribor rates is a logical reaction. This also explains why LIBOR remains relatively flat. Having said that, if debt fears in Europe come to fruition, they will undoubtedly manifest themselves in higher Euribor rates. This is a metric I will be keeping a close eye on going forward.
The United States
Over the past week or two, a whole host of economic indicators have come in below expectations. GDP growth for the first quarter was 1.8%, below the market expectation of 2%. Further, most economists have revised their GDP growth forecasts lower in the past week. Initial jobless claims have increased over the past month. Chicago PMI and consumer confidence both came in considerably below expectations. Wednesday’s ADP employment report showed a gain of just 38k private sector jobs, well below the 170k expectation. And finally, the Case-Schiller home price index released Tuesday shows that housing prices are falling again and could be headed into a double-dip.
This economic weakness is also being reflected in surprisingly strong demand for US treasuries. Treasury yields are at their lowest levels in over 5 months. With the Federal Reserve winding down its quantitative easing program, one would expect prices on treasuries to increase, but instead demand from investors is driving prices lower. This trend shows an increasing level of risk aversion and could be signaling a significant pullback in equities.
With regard to the US’ debt position, I’m actually fairly optimistic. The demand for treasuries shows that the US is still able to finance its debt relatively cheaply. Further, Republicans made it clear this week that they will not pass a bill raising the debt ceiling without budget cuts attached. I’m fairly certain lawmakers understand the importance of the debt ceiling, but budget cuts are necessary and I’m in favor of political tactics that will bring about those cuts. Budget cuts are necessary and lawmakers that think otherwise will likely not be employed for very long.
Outlook and Trade
I think the confluence of all the above factors paints a rather bleak outlook for risk assets. I am quite confident that a Greek default is a matter of time, but when that actually happens remains unclear. Given the ECB’s attempt to downplay the possibility of a default, I expect this is news markets will receive on a Monday morning after euro-zone member countries fail to reach consensus on additional loans. While markets have already begun pricing this event in, I believe its actual occurrence will likely initiate a second wave down for equity/commodity markets and the beginning of a double dip recession.
Although it seems as if the crisis has moved east to the euro-zone, the United States is far from insulated. The recovery staged over the past two years is the result of unprecedented capital injections and asset purchases by the Federal Reserve. At the end of the month the Federal Reserve will stop its quantitative easing program that has kept interest rates artificially low. While not an actual interest rate hike, rates should appreciate marginally. I believe this is ultimately bullish for the dollar and bearish for risk assets like equities and commodities.
If my assumptions outlined in this article are correct, there are plenty of ways to trade it. Investors have plenty of options for short positions – index ETFs, financial sector ETFs, European banks, etc. In my experience though, shorting requires fairly accurate timing and a shorter trade duration, which is not particularly applicable in this case. I looked into put options but I was unimpressed with the potential upside given the cost. All of this leads me to a trade I think is prime to exploit this situation.
Part of the recent rally in equities and commodities has come at the expense of the US dollar. The Federal Reserve’s quantitative easing program systemically devalued the dollar to inflate asset prices and slightly ease the US debt burden. As quantitative easing winds down, the dollar should begin to appreciate. However, it is on a relative basis that the US dollar is so attractive at these levels. Given all of the uncertainty surrounding Greece and the euro zone debt crisis, I think it is very likely that the dollar appreciates against a weakening euro. Should Greece serve as a catalyst for a double dip recession, it is very likely that the US sees a similar, if not stronger, flight to safety rally as in 2008.
To position myself, I’m using call options on the Proshares Dollar Index Bull ETF (UUP). The dollar has been unloved by investors as of late and that is translating into relatively cheaper options pricing. With the markets unable to break through recent highs and the still unfolding euro zone debt crisis, the dollar is a safe investment that I believe will appreciate better than most investors are expecting. I’m allocating using a 60/40 split between the Sept. $20 and the Dec. $22 calls.
The dollar put in a solid base around the $73 level at the beginning of May. Since then it has traded higher, pulling back to the lower Bollinger band. It appears to me that it is in the final stages of a bearish-to-bullish reversal. The real test will be whether the dollar index can break the major resistance trendline around $76.50. A break to the upside would be a very bullish indicator and would likely indicate a run to at least $80.
The other side of the dollar index trade is the EUR/USD. Given that the euro accounts for more than 50% of the dollar index, its performance is heavily weighted to the EUR/USD. While the dollar index was forming a base at $73, the EUR/USD was testing the $1.488 level. After several attempts, it failed and broke the support of an upward channel trend. I believe this trend reversal is quite significant and greatly strengthens the case for a dollar index bearish-to-bullish reversal. Similarly, I’m watching the major support trendline around $1.37.
Regarding my rather bearish sentiment towards the broader equity indices, I’m closely watching major support trendlines going back to the lows in March of 2009. A break below these trendlines would be quite bearish for the equity markets. With regard to the Nasdaq composite, it has tested resistance at the 2007 highs near 2800, though it has not held above this level. A significant break above 2800 with staying power would be bullish for equities broadly, though I think this is unlikely.
Additional disclosure: UUP calls Sept. $20, Dec. $22