How To Play A Possible Eurozone Breakup

Jun. 8.12 | About: ProShares German (GGOV)

As recent events amply demonstrate, a complete break-up of the Eurozone has moved from an unlikely event to something that is a distinct possibility. The Spanish banking system is near collapse, Greece may essentially vote itself out of the euro on June 17th and I am sure there would be knock-on effects in Italy as well.

The situation looks so dire that Irish bookmaker Paddy Power PLC has even begun posting odds on a complete Eurozone break-up as well as on the order in which countries will leave. According to an article in Canada's Globe and Mail, the odds for a euro zone breakup by the end of 2012 are 4/6 and 2/9 for 2015. As for which country will leave first, the article notes that Greece's odds are 3/10, while its 7/1 for Portugal, 8/1 for Ireland, 12/1 for Italy, Germany and Spain, and 14/1 for France.

While no one can be sure what will happen in the future, I think its fair to say that the possibility of a Eurozone breakup is high and that it would behoove investors to consider how to both protect themselves and/or even benefit (to benefit sounds crass I suppose) from a Eurozone breakup. One clear option is PowerShares DB USD Index Bullish Fund (UUP). UUP has 58% of its assets in a Long USD/Short EUR trade. Another option is to buy puts on the CurrencyShares Euro Trust ETF (NYSEARCA:FXE), which is the ETF tracking the value of the euro.

Another way to play a possible Eurozone breakup is to consider what might happen to the new national currencies that would replace the euro. For example, Greece would presumably go back to the Drachma, Spain to the Peseta, Italy to the Lira, Germany to the D-Mark etc. One question to consider is how the new national currencies would trade in a post Eurozone breakup? After some research, I found that Nomura Bank had done a study in December on what the fair market value of 11 new European currencies might be:

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What's interesting is that according to Nomura, every single new European currency except the D-Mark would decline, with the new PIIGS currencies plunging anywhere from 27% (Italy) to 57% (Greece). What I also found is that as much talk as there is about Greece or other PIIGS leaving the Eurozone and thereby catalyzing the complete breakup of the euro, one other option being discussed is that Germany itself might choose to leave the Eurozone.

A German departure might actually be good for the Eurozone, as the remainder of the euro would drop in value while the new German D-Mark would soar against the old euro, thereby producing the competitive re-balancing the continent desperately needs. According to a recent article in the New York Times, there has already been huge amounts of capital being transferred out of banks in crisis countries like Spain into German banks, which demonstrates that Europeans are clearly thinking along the same lines. Given the Germans' well deserved reputation for conservative fiscal prudence, I believe that the new German D-Mark might even rise quite a bit against the dollar itself.

I like the idea of playing the scenario above by going long German stocks or bonds, perhaps with a simultaneous short position in stocks or bonds of one of the PIIGS' countries. The option I find most attractive is the new ProShares German Sovereign/Sub-Sovereign ETF (NYSEARCA:GGOV), which is linked to the performance of the Markit iBoxx EUR Germany Sovereign & Sub-Sovereign Liquid Index. I would image there would be a huge rush to safety in Europe, with the D-Mark (perhaps along with the Swiss Franc) being seen as one of the ultimate safe havens. German government bonds would therefore likely soar in value, and it seems not completely beyond the realm of feasibility that we could see the German 10 year bund hit the 1 per cent yield level.

Another option to consider is to buy the iShares MSCI Germany ETF (NYSEARCA:EWG), while simultaneously shorting the iShares MSCI Spain Index Fund (NYSEARCA:EWP). Even if the Eurozone does not break up, it is still a fair bet that German stocks will outperform Spanish stocks in the coming months, and even if both the DAX and IBEX go down I am guessing that the IBEX has more room to fall.

If any readers have other ideas about how to possibly play a Eurozone breakup via a strong D-Mark, I would be really curious to see your thoughts in the comments section.

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