Here's Why You Should Short European Stocks

 |  Includes: EEA, EU
by: Colin Lokey

European shares closed lower Monday after German Chancellor Angela Merkel opined that there is no guarantee that the Greek bailout will succeed. Merkel's comments came as German lawmakers are set to vote on the 130 billion euro rescue package for embattled Greece which sits at the precipice of disorderly default. Merkel did suggest that parliament approve the rescue package, noting that the benefits outweigh the risks (a pretty flimsy sales pitch for something that costs nearly $200 billion). With the Greek bailout in place and the ECB set to offer a second round of unlimited three year, low interest loans to eurozone banks on Wednesday, many investors may be considering a reentry into European equities. Such a move may prove ill-timed.

Far from alleviating the crisis, recent maneuvers to aid Greece and boost liquidity may well have set the stage for a recurrence of the crisis further down the road.

Perhaps the most important indicator of impending doom is high borrowing costs. When demand is weak for sovereign debt at auction, countries are forced to pay a higher interest rate on their bonds to attract investors. Once the cost of borrowing exceeds 7% (as it did for Italy late last year) it becomes 'unsustainable' causing whole nations to effectively be shut out of the debt market, a prospect that can quickly spark a liquidity crisis. The 'troika' (ECB, EU, and IMF) may have inadvertently set up Italy, Spain, and Portugal for weak debt auctions by forcing losses upon private creditors as part of the Greek debt swap. Some private creditors have sworn off purchases of sovereign debt (Commerzbank (OTCPK:CRZBY) of Germany is one example) after being forced to take 70% losses on their holdings of Greek debt while the ECB swapped its own bonds for no loss at all. Understandably, many creditors did not understand why the ECB go out scot-free while every other holder of Greek bonds was forced to pay the price. Without the support of the private sector, beleaguered nations may find it difficult to raise cash in the debt market.

Another threat to borrowing costs may be the LTROs themselves. One reason why the ECB's Long Term Refinancing Operations have been so successful at stimulating demand for distressed sovereign debt is that banks have been able to use money borrowed from the ECB at 1% and purchase Italian and Spanish debt yielding 4-7%--this is known as the 'carry trade.' Because the LTROs have been so effective they may now become a victim of their own success. The LTROs may be self-defeating for the following reason: As banks purchase more sovereign debt with funds borrowed from the ECB, interest rates on those bonds fall, making the carry-trade that much less attractive. In other words, the more sovereign debt banks purchase, the lower the rate on that debt and thus the lower the spread between the debt purchased and the rate paid to the ECB for the initial loan. If the difference between the rate earned on the debt and the rate paid to the ECB tightens enough, banks will cease to make the trade and, as a result, demand for distressed debt will dry-up.

For these two reasons, Italy's and Spain's borrowing costs could rise again in the not-so-distant future. If this happens, Europe could find itself right back where it started. Short ETFs that track European shares at the first sign of strength.

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