sovereign debt crisis in Europe threatens to squash global risk appetite and send not only Europe back into recession, but perhaps trigger another global financial crisis.
When the global financial crisis erupted in 2008, it exposed the structural flaws of the European Monetary Union (EMU), the then 9-year old concept of monetary unity between sixteen European members. Since then, the crisis in Europe has only worsened.
European officials tried to sweep this crisis under the rug. They denied its severity and then made shocking, empty promises that they were willing to absorb the damage at any cost.
Now the question is:
Will 2011 Be the Year the Euro Collapses?
The challenges ahead for the euro zone suggest that it will.
Investors may think a euro collapse is strictly a risk to their investments. But the fallout in Europe could also offer the biggest investment opportunity in 2011. Either way, the events as they unfold command attention and respect.
Nearly $1 trillion of sovereign debt needs to be refinanced this year in Europe. And nearly $1 trillion of European bank debt needs to be refinanced in the next two years. All will require much higher interest rates than were enjoyed last year this time — every euro of the €750 billion European Financial Stability Mechanism (EFSM) could be called on.
But we’ll likely find that this mass-scale rescue plan offered by Europe and the IMF in the middle of 2010 was nothing more than talk.
Moreover, Europeans who have been forced into austerity may stop the music first. What I mean by that, is private depositors of European banks might not stick around to see how it all plays out.
According to the Bank of International Settlements (BIS), European banks sit on $2 trillion of debt from the PIGS nations. Indeed, a vulnerable situation.
Before the ECB started buying government debt directly from these countries in 2010 to keep them breathing, they indirectly supported their sovereign debt markets by making ultra-cheap loans to European banks. Those same banks then bought the shaky sovereign debt in Europe.
So a default or restructuring of any one of these countries would pose serious problems for the European banking system, and likely spread into a global financial crisis that could make the subprime crisis pale in comparison.
In Ireland, a country that has been pulverized by its banks’ fast and loose lending practices, we’ve already seen a 10 percent year-over-year withdrawal of deposits from its banking system in recent months. A continued “run” on Ireland’s banks could quickly bring the façade of European/IMF rescue to an end. And it’s safe to expect similar runs on the banking system across Europe.
As you might imagine, these problems are, and will continue to be, expressed in a lower euro.
But even with the above in mind, the euro still sits 14 percent above purchasing power parity vs. the dollar.
Plus, given all of the government intervention around the world in recent years, market participants have convinced themselves that governments can impose their will on nearly everything, including saving the euro.
So we’ve seen forecasts in recent quarters for the euro to return to 1.50 versus the dollar and beyond. But if politicians could avert every problem and every disaster, we would never have economic downturns or even a single downtick in global stock markets.
If you factor in the overvaluation of the euro and the market’s misperception of its safety, a fallout could be quick and violent as people scramble to find the exit door. That presents risk to global markets, but also opportunities for investors.
The Euro’s Problems Equal Opportunity
As we’ve seen, this global economic crisis is far from being the “contained” event most global officials thought it would be back in 2008. At one point there were over 60 countries simultaneously in recession. So clearly the “Great Recession” has affected everyone worldwide.
And here’s some important perspective: History shows us that the deleveraging process of the decade-long global credit buildup is likely only less than halfway through!
So it’s safe to expect the shocks and crisis to continue. Yet it is possible to avoid the damage and capitalize on the opportunities.
Take a look at the chart below. It shows the two-year downtrend in the euro, with the path of the declining channel projecting parity versus the dollar, possibly by year end.
With the advent of exchange traded funds (ETFs), it’s easier than ever to take advantage of this opportunity — or to hedge against this outcome if you have existing exposure to the euro …
You could consider shorting the CurrencyShares Euro Trust (NYSE:FXE), or buy the ProShares UltraShort Euro (NYSE:EUO), an ETF designed to rise 2 percent for every 1 percent decline in the euro.
And if you would like more in-depth analysis and strategies on capitalizing on the opportunities in the currency markets, check out my World Currency Trader. For more information click here.
Money and Markets (MaM) is published by Weiss Research, Inc. and written by Martin D. Weiss along with Nilus Mattive, Claus Vogt, Ron Rowland, Michael Larson and Bryan Rich. To avoid conflicts of interest, Weiss Research and its staff do not hold positions in companies recommended in MaM, nor do we accept any compensation for such recommendations. The comments, graphs, forecasts, and indices published in MaM are based upon data whose accuracy is deemed reliable but not guaranteed. Performance returns cited are derived from our best estimates but must be considered hypothetical in as much as we do not track the actual prices investors pay or receive. Regular contributors and staff include Andrea Baumwald, John Burke, Marci Campbell, Selene Ceballo, Amber Dakar, Maryellen Murphy, Jennifer Newman-Amos, Adam Shafer, Julie Trudeau, Jill Umiker, Leslie Underwood and Michelle Zausnig.
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