A recent article by Spiegel explains that leaders of countries and businesses in Europe are secretly planning for a complete collapse of the EU. The article is shocking because it shows a Europe beyond what we are reading about in the mainstream news, by pointing out what's going on in the background, unknown to most:
Companies, sensing the potential risks, are already doing as much as they can today to prepare for a European monetary storm. For instance, they are financing deals in the peripheral countries locally, so as to avoid currency risk. Investment bankers report that companies are receiving loans almost exclusively from banks in their own countries. Where cross-border transactions are unavoidable, banks are engaging in hedge transactions. IT systems are being prepared for a Europe with multiple currencies. And whenever they can, banks are establishing liquidity reserves or depositing money with the ECB.
Meanwhile, German leaders have suggested a financial transaction tax, and vehemently oppose any debt sharing. Meanwhile, Italy's oldest bank is being restructured, and CDS on Spain's largest banks are at record levels, indicating a possible downgrade to junk status.
All of these indications point to a brewing storm in Europe, a storm the world has never seen.
Economists with the Dutch bank ING have calculated that in the first two years following a collapse, the countries in the euro zone would lose 12 percent of their economic output. This corresponds to the loss of more than €1 trillion. It would make the recession that followed the bankruptcy of investment bank Lehmann Brothers seem like a minor industrial accident by comparison. Even after five years, say the ING experts, economic output in the euro zone would still be significantly lower than normal.
This number does not include losses for foreign companies operating in Europe, or losses to investments made by both businesses and individuals.
European Union History
The full history of the EU goes back to post World War 2, when the European Coal and Steel Community was created in 1951 with the Treaty of Paris. Then in 1957 the Treaty of Rome was signed to create the European Economic Community, laying the foundations for the modern European Union. The idea of an economic union in Europe had many motivations, not the least to bind previously warring European countries together economically. During this period, Europe was rebuilding infrastructure and social mechanisms, with much of the East left to be controlled by the USSR until 1989. The new rebuilt Europe learned to deal with multiple sovereign currencies, each with it's own tarrifs and trade rules. The European economy gradually grew, and more confidence was built for a wider economic union, a currency union.
The US was at this time the backbone of the global economic system, providing a stable currency as a benchmark, and by providing actual financing and materials to a tattered Europe. But the US overstretched their advantage, creating alot of US Currency to finance the Vietnam War and other endeavours. This caused a weary West Germany to pull out of the Breton-Woods agreement, starting a string of events called the Nixon Shock, creating modern Forex as we know it.
There are many differences between then and now, but most importantly, the model which the EU structure was built on, was designed during a time of a US Dollar hegemony, where the USD was backed by gold. With fixed exchange rates, and a USD tied to Gold, the Euro would be alot more feasible. Also modern markets are electronic and instantaneous, allowing investors and speculators to move money from one currency to another in a few seconds. During the recent bank run in Greece, it happened electronically, with only a few physically visiting their bank branch.
The most obvious consequences will be extreme volatility, a lack of liquidity in many markets, large amounts of 'black swan' events, and a general disruption to the global economy. Investors should look to consultants to utilize hedging strategies for their portfolios. While no one knows how the situation will play out, it is possible to model scenarios and plan accordingly. For those looking for pure speculation, the Spot Forex market may provide many opportunities especially if the Euro is dissolved, and a return to sovereign currencies in Europe is enacted. If I.T. systems are already capable of accepting payments in French Francs and Spanish Pesetas, it indicates that business leaders think a collapse is 'very likely'. With the introduction of new currencies to a modern electronic Forex market, combined with the economic storm brewing in Europe, volatility could be immense.
Strategies such as EES "Strangle the Euro" which are plays on volatility, not market direction, will be the safest plays to capitalize on the market volatility with the maximum effect.
Jim Cramer doesn't like deep out of the money options. In a market boom, or normal times, he may be right. But with such a severe storm brewing in Europe, which will spread around the world, the best strategies will be to play deep out of the money options, or 'black swan' trades. For example, purchasing a EURUSD spot Forex put at 1.15, 1.10, and 1.00. There are banks who will sell it to you for a very small sum, because the Euro would need to move more than 10% to even make them viable for most traders, a big move for a currency. However, if Greece exits the Euro and returns to using Greek Drachma, this can happen in a few days.
Unfortunately, many of the strategies that will be most successful cannot be recommended because the instruments do not yet exist! For example, purchasing call options on Greek Drachma, if enacted, could provide a great way to capitalize on a Greek recovery. Purchasing puts on Italian Lire will be a great way to bet on an Italian debt crisis.
Forex Risk Disclosure - Click here to read
The risk of loss in trading foreign exchange markets (FOREX), also known as cash foreign currencies, or the FOREX markets, can be substantial.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.