The Nightmare In Europe Continues, But Does The Short?

Includes: EUO
by: Ananthan Thangavel

The European situation continues to evolve into a nightmare. From anecdotal evidence, it appears that the ECB needed to step in and buy bonds each day this week to prevent a complete meltdown. Even still, European bonds had a rough week overall.

The following charts show this week's action in Italian, Spanish, and French 10 year bonds.

Chart courtesy of 11/21 Commodity Analyst Newsletter

Chart courtesy of 11/21 Commodity Analyst Newsletter

Chart courtesy of 11/21 Commodity Analyst Newsletter

All three countries were under heavy selling pressure this week, causing the ECB to step in at multiple junctures. To highlight the fever pitch of the action, Thursday's chart tells the European debt story. The ECB bought bonds, in a presumably very large size, directly before debt auctions by Spain and France. The ECB tends to concentrate their bond buying immediately preceding debt auctions because they are trying to drive down the yields so that investors will accept lower yields at the auction. However, it is becoming painfully obvious that the ECB is the only party supporting these bonds.

As we have stated before, European banks have about 1 trillion euros of debt coming due over the next year, and are also being forced to raise capital ratios by June 2012. What this amounts to is massive forced selling of debt. Because European banks' non-sovereign holdings are concentrated in proprietary loans that are illiquid and difficult to value, the first thing they will sell are their sovereign debt holdings. Add to this fact that sovereign debt is becoming increasingly volatile and losing value quickly, and you can see that it won't take much to set off everyone rushing for the exits at the same time. Banks from Soc Gen to BNP to Deutsche Bank have all indicated their intention to continuously decrease their sovereign debt holdings.

At this point, the only idea keeping the markets where they even are is the notion that the ECB will reverse their stance on monetization of the debt, and start printing euros to backstop Europe's sovereigns and banking system. Literally everyone in the market is banking on this, from the bulls buying stocks, to the bears shorting the euro. As contrarians, we are forced to ask the question, what if this doesn't happen?

While admittedly we are still in the camp that the ECB will most likely print, there have been some important signs lately that this may not necessarily be the case. First of all, German and ECB officials are now saying on a twice-daily basis that monetization of the debt is not an option. The market is wholesale betting that this is merely just posturing, but it is worth considering that maybe these officials are trying their best to indicate to the market that monetization of the debt is not a possibility.

However, even more concerning is Germany's recent political overtures. A leaked document this week showed that Germany is making plans multiple sovereign insolvencies, which would then trigger "European Union" (read: German) control over those countries' politics and economics. If this happens, it would be more shocking than a Lehman moment ever was, in that essentially Germany would stand idly by as more and more countries fell, only to completely exert their political will on them. Already, Italy and Greece have forced out their leaders for essentially EU puppet governments. In a hugely perverse system of incentives, it may actually benefit Germany for these countries to experience more sovereign debt troubles. While the world would be thrust into a renewed recession, politicians are much more concerned with increasing their power rather than doing what's best.

If Germany could usurp Europe's sovereignty by way of withholding further financial support, this may prove too enticing a prospect for their politicians to resist. With the German population already disgusted with the perceived bailout of other European nations, this seems a golden opportunity for Germany to exert their political will for generations to come, even if it means enduring short-term financial pain. As it becomes clearer that there is no solution other than money-printing, and that a European depression is unavoidable, Germany could easily decide that they might as well support their own banks, allow these other sovereigns to go as they will, and pick up the pieces afterwards in return for a complete sacrifice of national sovereignty. Such a scenario has not even been partially priced into the market, and could cause catastrophic consequences.

Germany's horrific experience with hyperinflation, specifically referenced by German officials this week, is also extremely strong motivation to not go down the money-printing road. In fact, one of the reasons that the ECB was created in the first place was to ensure that this type of monetization does not occur.

When viewed from this angle, it is not surprising that the euro is as high as it currently is. Considering global currency wars, the euro is actually the most "hard money" currency there is right now. The U.S., Britain, and Japan have all engaged in massive quantitative easing, which is just a thinly-veiled form of currency devaluation. Japan has intervened three times this year (all unsuccessfully) to weaken their own currency. Excluding Europe, the developed world is literally trying to devalue their way into prosperity. Even the former safe haven Swiss franc has drawn a hard line in the sand and warned against investors owning their currency.

Ironically, even though the ECB is easily the most hard money of the major currencies, it has still lost value against all major currencies this year. The current decline can be attributed to investors anticipating a reversal in ECB hard money stance, as well as investors liquidating euro-denominated assets due to impending recession in Europe. Given the Fed's constantly-looming guillotine of further QE, it is not surprising that international investors have been reluctant to turn to the dollar as an alternative. Instead, they have turned to gold, crude oil, and other commodities, as evidenced by gold's incredible performance on the year, as well as crude's incredibly stubborn advance.

However, eventually macro fundamentals will come back into play, and the dollar will strengthen, causing commodity speculators to greatly cut their longs. In scenario 1, the ECB will print money, causing the euro to drop hugely in value against all competitors, with the dollar being the primary beneficiary. In scenario 2, the ECB will not print, causing a major depression in Europe and multiple sovereign bankruptcies, which will cause investors to liquidate European assets and invest elsewhere. The downside for the euro is much greater in scenario 1, and certainly this is scenario that the market is betting on. But the euro should suffer from pure macroeconomics in scenario 2, even if it is only in the short-term because the Fed will initiate more QE in response to a deep European/global recession. This is why the net short position on the euro reached the 2nd-highest level this year this week. Investors shorting the euro are betting on a heads I win, tails I win scenario.

While we believe this is the case as well, the extremely large net short position in the euro is worrisome. Any perceived good news for the euro (or bad news for the dollar) could cause a powerful short-term rally. Also, if the ECB maintains their hard money stance until the end, the euro could actually trade higher in the long-term due to almost assured renewed easing from the Fed, even as European stocks and European sovereigns get decimated.

Trade Recommendation

For the reasons discussed above, we recommend covering euro shorts at a price of 1.35 or better. To be sure, this is not because of a bullish view on Europe, but rather an acknowledgement of how crowded the trade is, and the fact that there are other, better shorts in the market right now that play off the same theme.

Investors who wish to maintain exposure could switch their short futures exposure to long put spread exposure instead to maintain a degree of short euro positioning with limited downside.

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

Disclaimer: All information included herein is the opinion of the firm and should not be considered investment advice. Past performance is not necessarily indicative of future results.