First, some fast and loose rules of thumb on how to read the market, based on the combination of SPY, GLD, UUP, and TLT, four of the most important macro indicators in the equities space.
- SPY and GLD up; UUP and TLT down: Risk-on based on monetary easing.
- SPY up; GLD and TLT down (UUP moderate change in either direction): Risk-on based on prospect of healthy real growth.
- SPY and GLD down; UUP and TLT up: Risk-off, Fed's hands tied.
- SPY down; GLD, UUP, and TLT up: Risk-off, crisis looming.
- SPY, GLD, UUP, and TLT all down: Systemic deleveraging, disaster upon us.
Wednesday was no doubt a day of deleveraging. It brought back memories of September 2008. Everybody needs cash in US dollars; never mind gold or Treasuries, when clients, brokers, and risk managers all call in to demand cash.
The driver was, of course, the euro drama, as has been the only driver since August. But it took on an especially menacing look since last Friday when Sarkozy and Merkel threatened Greece with the prospect of being kicked out of the eurozone.
I laughed out loud when I read it. Is the game of chicken set up wrong here? It's supposed to be Sarkozy/Merkel who have been trying desperately to hold the eurozone together. And it would be a huge liberation for the Greek people if they could leave, devalue drachma, default, and move on (see Argentina, Iceland, Russia for some recent inspirations). The only reason why Papandreou blinked in this wrongful game is that he's too much of a technocrat and a part of the euro elite obsessed with the United States of Europe dream. If there's functioning democracy in Greece, I suspect Sarkozy/Merkel would've been called on their utterly empty threat.
But on Wednesday things changed, and quite dramatically. Sarkozy/Merkel reportedly got serious about the idea of shrinking the eurozone, and in general paving the way for exits (DEM, finally?). What a noble idea! It was about the Franco-German idea of making nice to begin with. The peripherals just wanted to hitch a ride on low borrowing costs and the pride, whatever the latter means; they never expected to work for it.
Although the call for ditching the euro has been long and wide outside of the continent, anyone talking such nonsense at a Paris cocktail party would have been labeled a traitor or Anglo-Saxon agent. Not anymore. All we need now is two populist new leaders in Greece and Italy to take up this offer from Sarkozy/Merkel and stand up for their people, and the fat lady would start singing.
Sensible as it is to dismantle the eurozone, the road getting there will be full of risk. There have been plenty of doomsday predictions on how the fall of the eurozone would destroy modern civilization as we know it. But I think these predictions may have been exaggerated.
First of all, I for one am getting a severe case of Crisis Fatigue since 2008, so much so that, whenever someone cries wolf, my first reaction is "show me." Secondly, betting on a post-euro disaster is betting against human creativity. Bank runs, bankruptcies, exchange rates, trade settlements, et cetera -- yes, these are all real risks, but these are also all man-made problems, as opposed to an asteroid hitting Earth. They are at least solvable problems; human history is full of examples of us rolling toward the edge of a cliff in our fantastic fights, only to snap back into some sensibility and get away from the brink of total disaster. We're not quite as stupid as we're afraid of ourselves being.
If the unraveling of the euro really begins, there'd be some more deleveraging (which is fundamentally different from risk-off) until we sort out some viable plan. Financials (XLF, IXG, IXF, IYG, FAS, FAZ) would be hurt badly first and foremost, but with their deleveraging hurting everything. But as we go through the turmoil, there's at least the comfort knowing that at the end of the tunnel is a sustainable real solution and a healthy, divorced Europe free from the tyranny of the US of Europe imposed by the detached elite.
Little would change fundamentally, except that Europeans would get to be themselves with a renewed sense of responsibility and consequences. Because of this, I think all the mayhem would be transitory in time and limited in magnitude. Another way to look at this: All European leaders have lost credibility; changing course cannot be worse.
If the eurozone continues to be duct-taped together, then the drama would drag on with increasing risk of a disorderly break-up. The world would continue being hijacked by the day-to-day, hour-to-hour, even minute-to-minute whims of rumors, meetings, announcements, and leaks from the old continent. While orderly unwind of the euro is creative destruction, continuing kicking the can down the road is destruction period.
Now that we have seen a glimpse of pain, the calculation has changed; euro breakup has morphed from the worst case scenario to the best possible solution, and the only constructive and rational question is how to do it.
For those of you planning to stay in a bunker, I'd like to present a collection of articles on the euro situation, which I find highly enlightening and entertaining.
- Greenspan on cultural differences underlying the improbability of Euro.
- Michael Lewis on the same topic, only much more fun.
- Europe's insult diplomacy.
- Europe according to Europeans.
- How long before Europeans will be on each other's throat again?
Good luck trading, or have fun not doing it.