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We know Germany needs to pay, no matter what happens in Europe. The German banks lent to countries that can’t repay the debt. Either these countries need to default, or Germany needs to accept “potential” inflation. Despite this, Germany bullies the debtor countries into forcing austerity programs on their citizens.

But this is all about to change. It’s been clear for a long, long time the current price of the euro is really the average of two extreme prices – a 1.8000 EURUSD for the Germany/France axis, and a 1.0000 EURUSD for the mediterrinanin slacker caucus.

But what hasn’t been clear is just how weak the German position really is. It’s become obvious Germany is bluffing – and the bluff is about to be called.

Who is the country with the fewest options? Germany. It can’t commit more money to the bailout funds, because of domestic political pressure. At the same time, Germany doesn’t want to let the ECB solve the problem by purchasing the debt of Greece, Italy, or Spain – because it fears the inflation it might cause.

Then, it’s largely German banks stuck with the bad sovereign debt of Greece, Ireland, Spain, and Italy. Jack Sparrow pointed out the euro is one gigantic vendor financing scheme, and the biggest beneficiary is Germany. If the euro goes away, so does the export golden goose for Germany. Germany needs the euro to keep its export machine going.

Still, Germany is driving a hard bargain – aggressively raising the stakes over and over – forcing massive austerity programs on the problem euro countries in exchange for supporting small ECB purchases of their debt. It’s a huge bluff. These small countries can credibly threaten to exit the euro and force an immediate recession in Germany.

Germany would be destroyed if any country left the euro – because if one exits, it’s a matter of days before they all exit. This will push the EURUSD up, up, up. Plus, leaving the euro will cause an immediate default by these countries – so they won’t be able to borrow money for a while.

Germany’s export machine would grind to a halt, and its banks would be insolvent overnight. German products would go up 30% in price due to a gain in the euro, and their major customers wouldn’t be able to purchase the products anyway. The German banks would need an immediate bailout to keep functioning.

We know Germany won’t be kicking these countries out of the euro – the result is just too bad for Germany. So these countries must be thinking – what is the downside for me to threaten to leave? The Germans drive such a hard bargain default is starting to look downright attractive. These countries already face a long, never ending recession due to austerity programs forced on them by Germany. Why not choose a few years of pain over a few decades of misery?

It’s just a matter of time before one of these countries figure out they have the ability to place intense pressure on Germany with a credible threat to exit the euro. Now, throw in the incredible political pressure facing the governments of Italy and Greece. People in these countries are furious at the reforms pushed through due to inclusion in the euro.

There is only one way out of this trap –The ECB buys nearly all of the sovereign debt in a last minute attempt to prevent one of the PIIGS from leaving the euro. I suspect this threat has already been made -- quietly -- by Ireland and Italy. It’s part of the reason the ECB has been a bit more accommodating lately – and part of the reason Irish yields have been strangely quiet over current upheaval in Europe.

Some time very soon, Germany’s weak bargaining position will become widely recognized. Once this happens, it will be clear Germany can’t stop these countries from leaving unless it bribes them with ECB purchases. It can’t risk the countries actually leaving the euro. Increasing the bailout funds is a political non-starter. The only reasonable short term solution is for the ECB to push yields lower through debt purchases.

My strong feeling is the ECB purchases cause less political backlash than outright borrowing for German politicians. With those purchases come inflation fears – pushing the euro lower. This is something Germany wants. Germany desires a weaker euro – and this plan delivers a weaker euro.

This is why the new president of the ECB was so public about its plans to enforce austerity through central bank purchases. It gives up the entire game. If there is a credible threat to leave the euro, the ECB will purchase debt, period. This is why I expect the euro to drift lower and lower over the next several months and accelerate though the new year. It will soon become clear the country with the weakest bargaining position is Germany – and the easiest solution is for the ECB to purchase debt.

The Mercenary Trader team is already short the euro, so you should be already in a good position for this scenario to unfold.

EUR-USD Chart (click to enlarge)

The euro is up against a long-term support because the survival scenario stokes inflation fears. A break of the 1.32-1.31 area would be very bearish for the euro. Germany’s weak hand is about to be called, and once it is, the ECB will need to step in and purchase a debt. Once this happens, the EUR-USD will likely tumble.

This trade might last a while – the ECB will try to keep the purchases as small as possible for as long as possible. But once the world wakes up to the fact that it’s Germany holding the weak cards, the outcome is assured. The EUR-USD will tumble.