Why The Euro’s Drop Will Continue: Ramifications, Profit Opportunities

Note that even though concern has eased, for now, about a Greece default in the coming 7 weeks, there has been no sustained improvement in the Euro. This makes sense, because note how quickly markets shifted focus to Spain and Portugal as Fitch warned of more credit ratings downgrades, even as both countries attempt to slash spending.

The Euro’s behavior over the past days is likely indicative of its fate for the foreseeable future. Here’s why:

1. The essential problem: the EU has a sufficient supply of ticking bombs in the PIIGS to provide a steady supply of “crises of the month,” with no end or final price tag for resolving in sight, giving the market no real long term floor of support for the Euro. Its lifetime average is about 1.300, but it has never faced this kind of crisis, with so large a chunk of its members facing insolvency.

2. No cure on the scene: The only cure appears to be a comprehensive solution that satisfies bond markets that all PIIGS bonds are likely to be repaid at rates acceptably high to compensate for the risk involved, yet still affordable for the PIIGS. Nothing even close is even under serious discussion.

3. Risk Appetite No Help: The S&P 5oo has begun to pull back from its upper Bollinger Band, which typically means a test to at least to near its lower one. Gold, oil, and the EUR/USD are struggling or falling, and these often lead stocks. Given that most risk assets, especially the risk barometer S&P 500, are already at highs, the odds favor some pullback.

Next Crisis: The Pain In Spain?

This week’s big worry stems from Fitch’s threatened credit rating downgrade of Spain and Portugal (it also said the UK was too slow in its deficit cutting plans, but never mind). Consider:

a. Portugal’s last bond auction failed.

b. Spain will need about need to raise about 25 bln in July ($34.31 bln) just to pay off maturing bonds and debt, and will need to sell bonds to do so, barring rescue from another source. Greece has gotten no direct aid thus far. Like Greece, it needs to do this periodically, like most governments, just to keep going. Note the chart below.

02 March 10

As the table below shows, for now, Spain isn’t in real crisis, and has a lower debt load as a percentage of GDP, and also has lower credit default swap rates (CDS) then the other PIIGS block members.

04 Mar 10

However, those rates could soar if fears of default contagion rise or Greece’s crisis drags on into July.

If Greece or other PIIGS block members are in immediate trouble or also seeking to sell bonds at in July, that could make things much tougher for Spain, and any bond sale certainly more expensive. The EU may be unwilling to even consider more loan guarantees, if in fact it’s even willing to do so for Greece. Much depends on if and how Greece gets through April and May.

Note too that a Greek default would be a minor event compared to a Spanish or Italian one, given their much larger importance in the EU due to their much larger GDPs and debt loads.

For example, Spain’s GDP is $ 1.6 trillion, Greece’s is $357 billion.

A LOT of banks would be stuck with A LOT of bad bonds. Then what?

As we’ve noted before, just one PIIGS block default is likely to at least scare markets into raising rates beyond what these countries can pay, effectively shutting them out of the bond markets and placing them in de facto default as they await the latest wave of maturing bonds to make their insolvency official.

The second worst case scenario is another credit market and asset market collapse like in the fall of 2008 after Lehman Brothers’ collapse.

As for the WORST case scenario: No one can really tell how bad the WORST case scenario will be, because now the world financial system is far more debt burdened, and markets are more nervous. Most (?) of the stimulus bullets have already been fired. Now what?

Ramifications

As we’ve noted before, just one PIIGS block default is likely to at least scare markets into raising rates beyond what these countries can pay, effectively shutting them out of the bond markets and placing them in de facto default as they await the latest wave of maturing bonds to make their insolvency official.

The second worst case scenario is another credit market and asset market collapse like in the fall of 2008 after Lehman Brothers’ collapse. No one can really tell how bad the WORST case scenario will be, because now the world financial system is far more debt burdened, and markets are more nervous. Most (?) of the stimulus bullets have already been fired. Now what?

How To Profit, Or At Least Survive

Continue to use days of positive news on the EU crisis as further Euro selling opportunities, as long as the EU fails to come up with a solution for the whole PIIGS pen.

With the UK and Japan also looking at more stimulus and effective devaluation of their currencies, the US economy simply need not get much worse in order for the US Dollar to be better.

This Friday’s US Retail Sales take on special importance given the better than expected US jobs figures last Friday. If the retail figures are similarly upbeat, it will be the second time since December that the US has shown improvement in both critical Fed-influencing metrics. The first time we had that, the US Dollar rally began in earnest.

With the Euro, Yen, and Pound fundamentals getting worse and their central banks looking more dovish by necessity, a good retail reading could send the US Dollar on a new leg higher with real justification. Again, forex is all relative, and the least ugly wins.

Of course, the dollar isn’t in such great shape either, so it would be wise to use USD strength to diversify out of fiat currencies altogether, or at least into the very strongest, currently the CAD and AUD.

DISCLOSURE: NO POSITIONS, NO CLEAR SOLUTIONS, EITHER.