Position: Short Euro via FXE; Long Germany (EWG)
We want to make the quick point that although European equity indices look to be pricing in some form of bailout for Ireland today—most indices closed up +1.5% today across western and eastern Europe and Greece's ATHEX gained +2.6%—Europe’s sovereign debt crisis is far from over.
While this is an obvious point given the media’s attention on Europe’s debt and deficit ails, it’s worth restating our position that we believe there is a fundamental economic flaw in the Union of unequal states (the Eurozone), whereby states are effectively handcuffed from using monetary policy measures, such as inflating away debts or increasing trade competitiveness through currency debasement, to better maneuver economic developments.
While Greece got its €110 billion band-aid in May of this year and Ireland will soon get its own, the underlying “issues” afflicting the region cannot be solved with one-off bailout packages. On the contrary, we think that piling more debt upon debt is only going to compound the interconnected risk associated with the long-term issue.
While it could be argued that the Union of different parts proved beneficial to the whole in “good” economic times, the downturn from the world’s great recession is demonstrating a far different outcome and outlook for the Eurozone’s bound states.
In particular, we’d expect that bond yields for Europe’s fiscally imbalanced countries to maintain a wide spread over credit-worthy German paper as sovereign debt concerns persist into 2011.
As the chart below shows, despite the performance of today’s equity market across Europe and a slight decline in government bond yields from the PIIGS since an immediate term high on 11/11, we’d expect government yields across Europe’s periphery to continue to rise.
As yields push up so too does the cost of capital which further strains a country’s ability to refinance and raise debt, which in turn snowballs the perceived sovereign default risk. And so the cycle of credit risk, short of bold austerity measures to cut debt and deficit levels, persists gravely…
Matthew Hedrick
Analyst
