Greece And Portugal Out, Euro Up

Includes: FXE
by: Macro and Cheese

It's clear now: Greece and Portugal are out. In an effort to ensure the survival of the Euro, the Eurozone is constructing a firewall. The seventeen member countries are either within the protective wall, or outside of it. The Greeks has been out for a while, and as of this month, the Portuguese also find themselves outside the wall looking in. This reorganization will lead to a stronger euro.

Portugal, Italy, Spain CDS
(Data source: Bloomberg)

Above you can see the "CDS spreads" of Portugal (blue), Italy (red), and Spain (green). These spreads represent the cost of insuring the bonds of these three countries, measured in basis points, or hundredths of one percent. The higher the cost, the greater the risk that those insured bonds will default. In other words, like golf, a low score means you're in good shape, and a high score means you need to work on your game. (Greece CDS stopped being quoted months ago as a lost cause.)

Note that this past month Italy and Spain have improved their swings significantly. The cost of Italian insurance has dropped from a high of 5.35% to Friday's closing cost of 3.99%, while Spanish insurance over the same period has fallen from 4.50% to 3.55%. But the cost of Portuguese insurance has soared, from 10.90% to 14.29%.

This insurance premium has real-life consequences, because it is directly tied to the borrowing cost of the issuers. 5-year Portuguese bonds now yield above 18%. With total debt approaching 100% of Portugal's GDP, the country is surely headed for default. When borrowing costs are this high, most of the money Portugal collects in taxes is going towards making interest payments, and this state of affairs just can't last.

Unless you've been, well, on a Greek island, you know that the Eurozone countries have been struggling with their massive shaky debts for the past two years. So far at least, the collective will to keep the euro alive has been extraordinary, with the stronger countries going to great lengths to keep the weaker ones afloat.

But resources are limited, and decisions have to be made. There is speculation that the countries paying for the bailout, Germany and France in particular, are deciding which countries of the pack can be saved, and which will have to go. Rumor has it that Greece will soon be culled from the herd. Based on CDS rates, the markets are telling us that Portugal won't be far behind.

For now, by all appearances, the bailout is on track. Greece has already been awarded EUR 110 billion, and Portugal EUR 78 billion, by the ECB and IMF. Markets are expecting imminent news of still more support for Greece in the coming days. The most recent talk is for an additional EUR 130 billion, but there are whispers of an even larger number of EUR 15 billion more than that.

It's tempting to think that with all that money being made available the Eurozone is serious about keeping Greece and Portugal inside the firewall, but this isn't necessarily the case. For one thing, most of the money being doled out to the wounded is going to their bondholders anyway. In other words, the "rescue countries" are effectively bailing out their own banks.

Instead, this bailout cash is probably best seen as a part of a severance package, an effort to make the weak strong enough to walk away. At the same time it shores up the lenders who overextended themselves in thinking that the untenable growth projections of the "PIIGS" were sustainable.

It's difficult to predict the timing of any sort of announcement, if in fact one is forthcoming. Since there seems to be a growing realization that these countries can't be bailed out forever, it seems to me this situation will come to a head sooner than later, possibly within weeks. If and when Greece goes, Portugal's move should come quickly, because the markets will rush to price it all in, and there's a danger the states could lose control of the process.

Depending on how things evolve, Greece and Portugal may not be the last countries to hit the exits. I have been told privately by one market participant that some European banks are shifting their European assets and liabilities around so that more and more of their balance sheets are from their own countries. In other words, Portuguese banks are selling off their Italian assets and buying Portuguese assets in their stead. This way, in the event of their country's exit from the Eurozone, the banks won't have to worry about additional currency risk. Their balance sheets would become denominated in, say, escudos, rather than in a complex mix of escudos and euros.

Teeth will be gnashing over any sort of Eurozone split, but in fact going their own way will help these countries to get back on their feet. A huge problem the weakest members are facing now is that their currency, the euro, is just too strong for them. That's because the euro is effectively a blend of 17 currencies, made of powerful northern European exporters as well as the weaker PIIGS. The euro is very cheap for Germany, but cripplingly expensive for Greece and Portugal.

Like any blend, the euro is just the sum of its parts. When the weaker parts go, the euro will represent a stronger blend of countries, and a stronger currency. It will go up. This is easily demonstrated if you imagine what would happen if all of the Eurozone countries were to leave, one by one, until only Germany remained.

Don't look for the euro to sell off on the "bad news" of Greece and Portugal making their exit, look for it to rise. From a tactical standpoint traders need to be nimble, because a second LTRO (code for European QE, or quantitative easing) will take place on February 29. The talk is that this installment will be much larger than the first LTRO (EUR 489 billion), and historically QE has tended to weaken the currency. As usual, the euro will be subject to cross currents, so we have to stay on our toes.

Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in FXE over the next 72 hours.