European Sovereign Debt Spells Messy 2011: Some Option Choices

Includes: C, DB, FXE, GLD, SAN, SLV, UUP
by: Michael Shulman

The Irish, a stiff-necked lot (I am half Irish, wonderful trait, that) are going to agree to an ECB/EU/IMF bailout, against their will. They did not get into their financial problems due to a profligate public sector; they did so through a profligate private sector, specifically their banks. Does this rescue mean problems with the euro are over? No.

The $750 billion bailout fund created in Europe this summer was used to help Greece and a good deal more of it will be used to help Ireland. There will not be a great deal of money left to help Spain and Portugal when they need help. Or Greece, when things go awry again next year. Simply put, European governments have borrowed too much, spent too much and it is all unraveling, with stopgap rescues calming markets temporarily.

Lots of pundits are scrutinizing details and missing the bigger picture in Europe. Forget day to day, think longer term, put the dots together and Europe is a mess that is going to get messier.

  • Bond markets are screaming “default, default.” Yields on the euro-denominated Greek debt are at an all time high compared to Germany; yields in Ireland are near that point and are rising fast for Portugal and Spain.
  • Greece missed deficit reduction targets put in place just a few months ago and they “promise” they will surpass them next year, sort of like saying “your check is in the mail.” Portugal has fewer problems but still needs to roll over a lot of debt and the higher the yields, the more they have to borrow as interest costs jack up their deficit. Spain’s economic, deficit and debt problems dwarf those of the other three countries and is a country too big to fail and too big to bailout.
  • There is no political will to increase the size of the bailout fund in the one country that counts – Germany. Chancellor Merkel is asking for tough new rules – with penalties for rule breakers – for countries exceeding EU targets for deficits and debt. She also wants bondholders to take a haircut on any future “restructuring" of sovereign debt. And without Germany, nothing happens. And the profligate countries will sign on to these new rules and break them due to domestic political pressure in a couple of years.
  • In theory, the ECB could do some quantitative easing – print money – to reduce yields. They have already said they will not do so and need the political buy-in of Germany, a country paranoid about inflation that does not exist. Next summer, the presidency of the ECB is turned over to a German.
  • The relative austerity being planned by European governments is going to lead to some unsettling civil unrest – nothing major but enough to spook some bond traders – and lead to another recession. The double dip in turn will produce pressure to increase spending and will also decrease tax revenues.

So what if Greece or Ireland or Spain default or “restructure” their sovereign debt? And bondholders do take a haircut? Say good-bye to the capital cushions and perhaps the capital base of the large European banks and some US banks, notably Citigroup (NYSE:C), would get hit too. Large European banks are more leveraged than US banks; the ECB quietly suspended some rules this summer allowing totally lousy Geek debt to be considered as part of the core capital of banks. This puts the ECB and the European banks in a box if Merkel has her way. Even if she does not, a sovereign crisis or default will hit the European banks hard. It will happen and they will get hit.

The bottom line: things will be very messy in 2011 and then a major financial crisis, something the leaders of countries on both sides of the pond call minor, will prompt the ECB to begin printing money with Germany’s reluctant agreement. Given Europe’s problems and organic growth potential, the euro is wildly overvalued, as are European banks. Traders should look at longer term put positions on the FXE, the ETF for the Euro, and large European banks notably Deutschebank (NYSE:DB) and Bank Santander (STD). A year long mess will also be good for the dollar and precious metals, so traders should look at calls on the UUP, the ETF for the dollar, SLV, the ETF for silver and GLD, the ETF for gold.