Italian Debt Woes Could Trigger Crisis; Time To Buy VIX Calls, Short French Banks

 |  Includes: ERO, VXX
by: Colin Lokey

As I write this markets are in freefall--the Dow is down 300 points amid fears the Italian debt crisis is quickly spiraling out of control. In case you haven't been following the news, yields on 10-year Italian bonds spiked above 7% today. Most economists agree that Italy, which is the eurozone's biggest sovereign debt market, cannot sustain the high borrowing costs, raising the specter that the Italians could be driven from the bond market altogether and forced to seek assistance from the IMF and ECB. Many speculate that the ECB is now the only buyer of Italian debt.

Under a new scenario posited by intelligence company Exclusive Analysis, there is a 65% chance of a banking crisis sometime between November 23, and November 26. The group tested a number of scenarios and has concluded that, in the worst case, the US, UK, Brazil, Russia, India, and China refuse to provide the IMF with more funding for eurozone bailouts and Germany refuses to provide more money to the EFSF. Next, the EFSF tries to convince the ECB to print more money to help Portugal, Italy, and Greece. The ECB ultimately refuses and a nightmare scenario ensues in which the previously agreed-upon 50% reduction in Greek debt is jeopardized, French sovereign debt is downgraded to AA, and bank runs commence first in Portugal and Greece and then in Spain and Italy. Finally, Greece leaves the euro currency and prints drachma, which quickly become worthless.

The think tank also imagines other, more rosy scenarios, but the fact that it believes there is a 65% chance of an imminent crisis is worth noting. Many of the assumptions underlying Exclusive Analysis's prediction are already coming true. The EFSF plan to absorb Italian bond holders' initial losses is in jeopardy as there are no investors currently buying Italian bonds. Additionally, the IMF has shown little interest in beefing-up its reserves, which currently stand at around 280 billion euros. Also, EFSF bond auctions betray a lack of confidence in France's ability to maintain its AAA rating. EFSF bonds are backed by Germany and France and the weak demand for the bonds at auction coupled with the rising spreads between EFSF bonds and 10-year German bonds indicates that investors fear a downgrade of France's sovereign debt to AA may trigger a downgrade of the EFSF causing its bonds to fall in value.

The challenge then, is to find ways to make money in an environment that is extraordinarily uncertain. First, you should consider getting long VIX call options. During the last financial crisis the VIX spiked above 80 on two separate occasions. You can also use VIX calls as a hedge on an existing bullish stock position. Another way to profit from a calamity in Europe is to sell the EUR/USD. This pair has traded almost exclusively on news out of Europe for a few months now--when the news is good, the Euro rises, when the news is bad it falls. If things get really bad, a lot of money could be made by being long the dollar against the euro.

Some would tell you to buy the Japanese yen as it has traditionally served as a safe-haven investment. However, as I have explained in other articles, the Japanese economy is largely dependent on exports and thus cannot withstand a consistently rising yen. The Japanese have already intervened once this month in an effort to curb the yen's rise and have indicated they will do so again should speculators drive the currency higher amid fears about Italy and Greece.

Also, given what we know about the likelihood of a downgrade of France's sovereign debt, it makes sense to short Societe Generale, BNP Paribas, and Credit Agricole.

Interestingly, this may not be the time to hedge your bets with commodities for two reasons. First, they don't seem to be trading in rational ways. By all accounts oil should be down given the uncertainty in Europe. Instead crude is rising. Also, gold should be climbing as investors typically buy the yellow metal as a hedge against market risk. While gold has come back a bit from a dismal showing in September, it still isn't rising as quickly as one would expect given the extraordinary level of fear that surrounds the eurozone crisis. Another reason to be wary of commodities right now is the fact that the collapse of MF Global has effectively increased volatility in the commodity markets by decreasing the number of contracts that trade hands on a daily basis.

Whether or not you believe the situation in Europe will precipitate a crisis on par with the 2008 financial meltdown in the US, it seems like a good time to be cautious. Given this, I believe owning dollars, VIX call options, and a few short positions in key French financial institutions will increase your chances of weathering the storm that seems to be brewing across the Atlantic.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.