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The Euro Is Dying


Time is of the essence, and the only ways out are via some combination of devaluation, default, and resolution of problem banks.

It was the best of times...

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It was the worst of times...

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Two different euro crosses, two completely different pictures. One is a picture of euro strength, the other of euro weakness. So which one is right? Is the euro a pillar of strength? Or not?

First, you have to understand the drivers behind each respective pair. For the EURUSD pair, it's simple: For all the Hellenic tragedies brewing in Greece, and for all the jokes about the Parthenon being offered as collateral to a bank (or worse, a pawnbroker), there is still a huge spread in funding rates between the two currencies. Three-month Euribor rates being indicative of euro funding rates and 3-month Libor rates for the dollar.

By my calculations, that's roughly a 125bp spread to borrow dollars and exchange them for euros to lend out. And with the prospect of future rate hikes coming from the ECB, that spread will widen because as most everyone knows, the Fed is now in the role of Lando Calrissian, cutting deals with Darth Vader even if it means freezing Han Solo (played by the Treasury yield curve) in carbonite. One other thing I've been thinking about as the market has moved on is this. The ECB withdrew facilities last year in an attempt to sound an "all clear" for the banking system. Well, it hasn't quite worked out that way. But hey, the spread is 125bps and I need to earn some coins somewhere, somehow.

But in this environment, that feels like picking up pennies in front of an oncoming steamroller to many. Especially when you factor in the fact that Spain's banks have left a flaming bag on their taxpayers' doorstep in the form of hidden bad assets. But as bad as that is, it seems that nobody in Spain wants to step out the front door and put the flame out. Because that usually means doing something messy and smelly. So, no, the EURUSD doesn't seem to be telling us the right message.

As my fellow professor Conor Sen pointed out (see Contagion Concerns From a 2007-08 CDS Trader), the EURCHF exchange rate is the real measure of risk on the European continent. Because unlike US dollars, Swiss francs are more fungible there. It's easier to swap euros for Swiss francs. And vice versa. And other than Germany, Switzerland is the most stable country there. Period. So following that exchange rate is a good sign of how risk averse the European system is. Conor also pointed out the following (emphasis, mine):

We've been getting these panic moves every three to four months since the beginning of 2010. Spreads for a country widen, EUR/CHF falls, stock markets fall, policymakers announce a bigger liquidity facility or do something else to regain market confidence, spreads back off a bit, and stocks go on their merry way. But the spreads and yields never fall back to their prior levels. EUR/CHF never bounces back as high. It's a problem Europe could fix by having Germany and France write a big check and then letting some of the PIIGS countries devalue their currencies or leave the eurozone, but so far they have been unwilling to do that. And we're running out of time.

And so what did we get? We got this. A debt extension out 30 years? A rollover of 70% of the debt into a combination of 30-year debt and AAA-rated zero coupon notes with the other 30% being cashed out? The cash-out piece is significant because I'm willing to bet that the bonds that are cashed out will not be redeemed at par. No, I expect them to be redeemed at a deep discount (based on current yields of Greek debt) which leaves the messy business of loss recognition to be attended to. And the capital plugging that goes with it. This isn't just kicking the can down the road. This is contracting an asphalt paver to pave more asphalt for the road so Greece can kick the can that much further.

And then what happens when Portugal and Ireland have their debt to roll over? And when they ask for more bailout aid, what will they be told? What will the gang that can't shoot straight do then? Italy and Spain are perilously close to being cast in with this bunch and as Conor pointed out, they are the firewall. All bets are off if Italy and Spain start seeing issues with floating sovereign paper in the debt market.

So our tale of two euros is not really a Dickensian story at all, nor is it a story about a troubled, bipolar youth who is missing his lithium. No, it's about risk aversion, spreads and risk-taking. It's about a two-tiered banking and economic ecosystem on the continent that shares only one currency, yet each and every country there can spend at its own discretion. It's the ultimate attempt at not only having your cake and eating it, but also eating a share of your neighbor's cake as well.

Time is of the essence and the only ways out of this mess (in some order/combination) are devaluation, default and resolution of problem banks. As Red in The Shawshank Redemption said, "Get busy living or get busy dying." The euro is doing the latter.
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