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EUR/USD breaks TREND and TAIL as Greek Concerns Flair


If we were to relate the European Sovereign Debt contagion to a boxing match, Germany (represented as the long-standing heavyweight champion) would be facing-off against numerous competitors in a league that includes the countries of France and the PIIGS, the latter of which collectively belong to the featherweight and welterweight divisions. The obvious mismatch would see Germany handily defeat the PIIGS—blood would spray deep into the 10th row and the sea of German fans would cheer!

Yet now consider that while Germany would happily throw the knock-out punch to see at least its featherweight competition never rise to its feet again (call them Greece, Ireland, and Portugal), Germany has ulterior motives, influence both by its fan club (the German populous and Merkel’s reelection efforts) and the Boxing Commission (think: ECB and Eurocrats from Brussels).

Firstly, Germany intuitively understands that it’s happy to beat up on its competition, but ultimately if it wants to fill the seats (think: export markets) it needs competition week in and week out. Secondly, Germany is being pressured by the Boxing Commission that so long as it doesn’t “finish off” its competition, the Commission will help split the PIIGS’ medical bills (think: bailout packages; SMP bond purchases; and EFSF) to ensure there are future rounds to fight.  

Germany, however, soon realizes that the competition is so mismatched that its weakest competition can hardly stand up straight, let alone see straight to protect (help) itself, and upset with the rising medical costs to “fix” its competition, the share of which is increasingly rising. Further, the game is so mismatched, that Germany fears it will lose not only its fan base who cannot justify the ticket price for such a match, but also that its poor competition will drag down its championship form (GDP).

Germany, the Boxing Commission, and the badly injured adversaries are at an impasse--what should be done?  German fans aren’t returning (Merkel’s popularity tanking); Greece, Ireland, and Portugal are in the ICU; and Spain and Italy need extra doses of morphine to deal with the pain.  The Boxing Commission and Germany are at odds. Germany’s only other competition, France, has caught a nasty cold with whispers of pneumonia. While Germany isn’t willing to let the league disintegrate, it’s also not in the position to continue to pay the lion’s share of the medical bills to fight another week. And so far Boxing Commissioner (Trichet) has yet to indicate that he’s willing to cover the rising medical bills should Germany skirt the bill. 

On the 29th of September the German team will hold a vote to see if they want to continue to pay the medical bills to insure future matches. Heading into the vote, many of the team’s strong voices feel that paying the bills accomplishes little: even with a healthy Greece, Ireland, and Portugal, there’s no competition for Germany. Further, fears percolate that should France be down and out for a long period and Italy and Spain require care, Germany will not be able to fit the bill. The larger question before the team remains: is it a larger risk for Germany to let the league disintegrate and lose its championship form, or continue to support its competition at a heavy cost so it at least has a body to throw punches at in the ring?  The fans seem unwilling to let this decision linger.

The “boxing tale” above presents some of the larger issues regarding European sovereign debt contagion and Germany’s leading position in the issue, all of which have heightened since the German government considered the impact of a Greek sovereign default on its banks over the weekend. While there are numerous moving parts in crafting “solutions” to this contagion issue, including political conflicts and solving for known unknowns on the sovereign and banking sides, what’s clear is that Germany’s vote on the 29th, a change in the ECB’s willingness or unwillingness to provide more fiscal support, and/or market forces may all have significant impact on the direction of this contagion.

We’re not currently invested in Europe via our Hedgeye Portfolio and don’t expect a quick fix to European debt and banking contagion risks and expect to see more downside in European capital markets from here as:

  1. Eurocrats refuse to accept default of member countries
  2. The EU Constitution does not account for measures to let a member country leave the Eurozone
  3. Stronger nations will likely vote against Eurobonds
  4. Countries (like Finland) will demand collateral for funds posted to the EFSF which will pinch the Greek state which doesn’t have the assets to cover the EFSF
  5. There’s no European-wide banking plan to recapitalize/write down peripheral exposure, or simply to let banks fail

Obviously the region’s common currency hangs in the balance. Our immediate term TRADE levels on the EUR-USD cross are $1.36 to $1.39. As Keith has stated recently, from “The Correlation Risk perspective, this cross remains the most important relationship in all of Global Macro. We like to say, “get the EUR/USD pair right and you’ll get a lot of other things right.” Both the TAIL ($1.39) and TREND ($1.43) for the Euro have broken expeditiously here in September.”

As we show in the 3 year chart below, we don’t see any longer term support in the EUR-USD until $1.20. From a calendar perspective, the Germany’s EFSF vote at the end of the month remains a critical catalyst, as does Troika’s report on Greece’s fiscal consolidation measures, the report of which is expected to come out at the end of the month and the findings of which will determine if Greece receives its next tranche of funding of 8B EUR, monies it’s desperately relying on to pay its bills.

European Risk Monitor: Blood in the Ring - 1. monday

European equity indices, especially banking stocks took it on the chin in August and are off to a bad start in September. The heavy weight German DAX is down a full -33% since its early May highs!  The point here is that no country is immune despite how impressive its right hand (balance sheet) is.

Below we include the Weekly Risk Monitor report from our Financials sector head Josh Steiner. It shows in particular the rising risk premium, reflected by CDS spreads, across the sovereigns and banks of Europe. Directly below we refresh our chart of 10YR yields of the periphery.  In particular, Italy has move back to 5.50%, and therefore is flirting closer to the 6% breakout level. Italy’s 54.5B EUR austerity program, which could pass the lower house as soon as this week, is weighing on this yield—both that the package gets passed and the terms are bold enough to arrest the country’s severe debt levels. Whether or not the Chinese come to Europe or Italy's aid (FT rumors today), we’re sure there are no short term fixes to Europe's  debt "crisis", especially if Eurocrats have their way.

European Risk Monitor: Blood in the Ring - 2. monday

European Financials CDS Monitor – Banks swaps also widened in Europe last week.  35 of the 39 swaps were wider and 4 tightened.   The average widening was 5.9%, or 25 bps, and the median widening was 21.3%.  Tightening was concentrated in the Greek banks, where swaps are already trading well over 1,000 bps. 

European Risk Monitor: Blood in the Ring - j1

European Sovereign CDS – European sovereign swaps went parabolic last week.  All the countries we track, with the exception of Ireland, hit a new high as of this morning.  Greek swaps are up 56% WoW as of this morning, rocketing to 3500 bps.  French CDS rose 23% WoW to a new high of 191 bps. 

European Risk Monitor: Blood in the Ring - j2

European Risk Monitor: Blood in the Ring - j3

Matthew Hedrick

Senior Analyst