The European Endgame

Includes: FXE, UUP
by: Michael Shulman

Is there a European endgame? Yes, re-capitalized banks, austerity budgets in countries with economies too weak to weather austerity, a very deep recession and a return to form for the region’s currency. The endgame of the current mess, regardless of how it plays out, is a euro worth a buck.

Why The Banks? European banks never wrote down their lousy assets from the post Lehman Brothers crash and many, especially German banks, are leveraged more than Lehman was when it went away. The Germans may seemingly be paragons of fiscal virtue but their banks have loaned a lot of countries a lot of money so they could by German goods, a not so virtuous cycle. When the Greek non-default default occurs, credit default swaps will not be triggered and banks everywhere in Europe will take a haircut on these assets. Ditto if and when Portugal goes bust and is the Italians do a non-default default. The banks will need more capital.

For political reasons Merkel is saying they must raise private capital first then we will see what we do. That would be funny if it were not tragic. What sane private investor is going to buy a bank stock or convertible knowing they probably will be diluted as soon as the ink is dry on their new stock certificates. If you agree with Michael Lewis’ opinion, expressed in his new book Boomerang, of the intelligence of the average banker at the German state banks, maybe these outfits will buy shares in each other. Hey, it could happen. What is more probable is European governments will need to re-capitalize their banks. And since they are all broke, and their citizens hate the banks, they will print money, somehow, to create that capital.

Bottom line: European banks need to be re-capitalized to repair damage from Greece and probably Portugal. And there is always the possibility the zone will break up or something near a default will happen with Italy and massive amounts of capital will be needed. Either way, central banks need to print money. Strike one against the euro.

Austerity Budgets: Austerity budgets – “let’s all be German!” is the mantra being chanted around Europe. Of course, German prosperity is built on grossly undercapitalized banks lending money to countries that buy German products., that is for another day. Greece’s new austerity budget will cause a Depression and barring a miracle, the country, when it needs to default, again, next year will opt to leave the euro. Italy actually runs a primary budget surplus – it runs deficits due to interest on its huge debt – and the country now needs to starve itself to pay off three generations of bad living, actually great living, bad public finance. This will cause a serious recession in a country that has grown maybe one percent a year for the past decade. Ditto for Portugal, ditto for Spain. Take those four countries and put them into deep recession or depression and there goes the rest of the European economy. German output is already falling, France and Britain are stalled, the PIGS are contracting as we speak, the math is inexorable. And the Germans will not lend them more money to buy stuff made in Germany.

Bottom line: Investors and bond buyers do not like recessions, especially in Europe where they cause political instability and will make it hard for countries to keep the false promises they made to bond buyers and to their own citizens. This recession will hit the euro, Strike two.

History: The euro has touched being a buck before -- that is how Germany got out of the self inflicted misery of integrating what was East Germany into what is now Germany. Europe collectively devalued via the bond and currency markets and it worked. When the European recession gets into full swing by the second quarter of next year at the latest, history will repeat itself. The euro will fall, blow past the $1.20 support level that has helped up for at least a decade and slide to parity with the buck. And not just because this is good for European exports, As the world becomes more uncertain and recession hits there, and China slows down, and U.S. politicians dither over the deficit and debt, people will still migrate to the dollar and to Treasuries.

Isn’t the U.S. also in debt and running deficits? The financial illiterates with the blow dried hair on CNBC and running for President are using a textbook from the 1930s and believe the dollar is being debased. Against what, a currency from Mars? Please, don’t say gold – gold has no intrinsic value, only perceived value, and this is the same for the dollar. It is the world’s reserve currency and the proof that this will not change is the world bought Treasuries when the U.S. Congress said we may default on paying off Treasuries!

Bottom line: European leaders will need the euro to fall due to recession and this will be accelerated by uncertainty that pushes people to the world’s reserve currency, the greenback. Strike three for the euro.

So what to do? Short the euro, go long the dollar, avoid direct trades of the currencies, use options on the ETFs, the FXE is the ETF for the euro, the UUP is the ETF for the dollar. There are other ETFs, these are pretty liquid and have options.

When? Whenever - Italy needs to roll over the 30 billion in euro bonds due this before yearend and the more than 300 billion in euro bonds due next year without paying exorbitant, unsustainable interest rates, assuming they can roll these bonds over at all. That is the great market fear – that bond sales will fail, Italy will run out of cash, triggering defaults on its’ bond. And Italy is too big to fail – the world’s eighth largest economy, third largest in the eurozone, second largest bond market in the world. Largest bond market in Europe. So what is next is political gridlock given the inability if European leaders to accept that time is not an independent variable – the longer this takes, the more expensive it becomes. And, if there is an exceptionally negative catalyst – Germany saying we have had enough, no more help for anyone, an assassination, riots, a bank failure – all bets are off, bond and credit markets will freeze. And if they freeze there, they will freeze everywhere. And your euro short, dollar long positions pay off sooner rather than later.