Today’s action in the forex markets has us scratching our heads. On one side, euro bulls are applauding the so-called breakthrough in negotiations, with the European Financial Stability Facility now authorized to purchase government bonds, and increasing the size and length of maturity of the Greek bailout.
On other hand, skittishness from the US debt situation has rattled forex markets to the point where they will sell the dollar against pretty much anything, yet equity market investors continue to happily buy stocks (and justifiably so given this quarter’s convincing earnings so far). As was the case at the end of June, the markets are once again headline-obsessed, and are not telling a coherent story.
The euro had an amazing rally today, almost 2% bottom to top shown by the chart below.
Today’s rally was precipitated by the details of today’s meeting being leaked, which showed a greatly expanded EFSF. The final terms were private creditors taking a haircut, a 160 billion euro package for Greece, lowering the interest rate on the loan to 3.5% and extending the maturity to 15 years. While this sounds like an amazing deal, the numbers don’t quite add up.
First of all, 3.5% is ridiculously low. With the US 10yr treasury note currently yielding 3.01%, this loan would appear to be even cheaper than US government borrowing rates. While I understand the US has our own debt problems, there is no way that Greece should be getting better financing terms than the US.
The EFSF is composed of “euro area member states” with EFSF bonds being backed 29% by Germany, 22% by France, but then interestingly 13% by Spain and 19% by Italy. This structure yields 2 important insights: basically Germany and France are footing the bill for this bailout, and 2 of the troubled nations themselves, Spain and Italy, are supposedly backing the EFSF. Not only will this new bailout in the never-ending string of bailouts be hugely politically unpopular, it will not be sustainable. What will happen when Portugal and Ireland need the same? One cannot borrow into eternity at low interest rates and a AAA rating.
The AAA rating of the EFSF could easily come into question. How can one lend money at ridiculously low rates to bankrupt entities, yet have a AAA rating? If the ratings agencies are serious about getting serious (as they purport to be with their repeated US downgrade warnings), one would think they’d have a field day with the EFSF.
The simple answer to how is this going to work, is that it isn’t. The EFSF is thinking they can float AAA bonds, and then in turn lend to bankrupt nations, and the EFSF bond investors will just take it smiling. Even if the EFSF is mostly funded by Greece and France without a huge amount of bonds floated to the public, these nations do not have an unlimited borrowing capacity either.
Moreover, the proclamation that the EFSF’s new ability to buy bonds on the secondary market will shield the euro zone from “speculative attacks” is pure folly. Remember back in 2008 when Bear Sterns, and then Lehman Bros executives kept whining about their share price being attacked by the big bad “shorts” and that nothing was in fact wrong with their companies? No investor is big enough to manipulate the entire European bond market, and blaming all of the problems in Spain, Italy, Portugal and Ireland on anonymous “speculators” is just a populist political copout to divert blame from those who really deserve it. Any time governments are crafting rules to combat those pesky speculators, it is a sign that things are spinning out of control. The list of these actions includes the no-short financial rule, the first-time homebuyer credit, government interventions in currency (Japan comes to mind), and so on.
In our view, the euro has a large amount of downside from here, and a very limited amount of upside.
Recently, I have heard rumblings that the short euro trade is the most crowded on the Street. As a contrarian-minded investor, this concerned me, so I decided to do some research. While determining currency sentiment is fairly difficult, there are some clues to be gleaned.
Option pricing reveals that investors are more willing to pay for upside exposure on the euro than downside. With the September euro futures contract trading at 1.435 today, the 1.425-1.375 put spread sold for $1,625 for a maximum profit of $4,625 upon expiration if the euro is below 1.375. The corresponding call spread to the upside, the 1.445-1.495 call spread sold for $2,000. In each case the max profit level is exactly 4.18% away from current levels, yet the call spread sells for 23% more than the converse put spread. This means that investors are pricing in a much greater chance of higher euro prices over the next 2 months than lower prices. This does not indicate a preponderance of bears, but rather a large amount of bulls on the euro.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
Additional disclosure: Short euro futures.