Overview of trade strategy for the European crisis.
The dream of European integration lies in tatters as the original sin of a pure monetary union without a fiscal union has been compounded by a series of policy errors. This has allowed the bond market vigilantes to reach the gates of Rome after the sack of Athens, Lisbon and Dublin. However, the air of inevitability that hangs heavy over Europe at the moment can dangerously cloud trading judgement. Even if the eventual outcome is correctly envisaged at outset, path dependent price moves can wreck a portfolio. The interconnectedness of a myriad of factors generated by the crisis considerably worsens risk-reward of tactical trading based on a partial view. Therefore, trading in this environment requires not only knowledge of the destination but also an awareness of the path. Sun Tzu’s maxim encapsulates it best: “Strategy without tactics is the slowest road to victory. Tactics without strategy is the noise before defeat.”
At this juncture, the fate of Greece is the most important determinant of how the crisis will proceed. The flow chart in Figure 1 above lays out a broad overview of the plausible paths.
The likely path (in red) at this point in time appears to be a default through a combination of bond buybacks and forced “voluntary” exchanges. The Greek template will then be assumed to apply to the other countries in similar situations: Portugal and Ireland in the first instance and Italy and Spain after. This is the reason for the current bout of peripheral weakness as market participants engage in a desperate and ultimately futile attempt to reduce exposure. With core country voters opposed to further bailouts leading to political deadlock, the onus will be on the ECB to calm markets until a credible plan can be developed. Bundesbank capture of ECB ensures that a timely and forceful intervention in the form of monetisation along with a reversal of the tightening cycle shall not be forthcoming. Contagion and disorderly defaults will take the EU to the brink of breakup. However, Europe’s political elite will be helped by inertia and initial lack of overwhelming support for secession, to keep the union together. At this point, ECB will have to abandon dogma and monetise to deal with economic and financial collapse wrought by sovereign defaults and mass bank failures. There is a risk that monetisation leads to inflation and complete loss of confidence in the Euro. This would severely test political will for the union as voters. At that point in time, unless there is a change from the current dismal political leadership, a breakup into more politically homogenous groups or individual sovereigns is likely. Such a cataclysmic event would generate considerable antipathy between EU members and require exiting members to financially repress their economies to provide stability. Attempts at economic growth will lead to trade wars and competitive devaluations.
Enlightened political leadership along with financial repression and coercion can stabilise the situation sufficiently to prevent a breakup. Ultimately a fiscal union can take place with members facing a significant loss of financial autonomy. However, this is a low probability event.
Wheels within wheels and reflexivity
The chart in Figure 2 above is a helpful overview and each step, but it is not static but changes with time. Each step can be expanded for further detail. The feedback loops operate between economics, markets and politics where a change in one feeds through to the others and their responses generate another change.
European leaders are working under the assumption that they have until September to work out a solution for Greece. This has caused uncertainty and fear in markets and led to spread widening. Over time, the toxic effect of austerity, rate rises and credit contraction in peripheral economies will be further revealed in economic data releases. This is clearly seen in Greece where unemployment has been consistently rising and government revenue falling. As budget deficits remain untamed, calls for further austerity and a halt to further aid will be made in core countries. Both will serve to worsen the market’s fears. At a certain spread and market dysfunction level, politicians will be forced into knee-jerk reactions such as placing restrictions on short-sellers of bonds and curbing CDS activity. This will exacerbate the problem and may lead to auction failures as participants shy away from Italian and Spanish government bonds. With refinancing interrupted the question of default and monetisation will have to be immediately addressed.
The first arrow of the flowchart can be expanded as below.
Eurozone is not enough
In a market operating on “risk on/off” with cross-asset correlations at the highs, analysing Eurozone dynamics is not enough. Other risk factors need to be considered such as:
China (growth concerns and credit fuelled asset bubble)
US (Debt ceiling and double dip recession concerns)
Middle East (Oil price shock)
Detailed discussion on each of these requires further analysis.
Putting it all together
Given the likely scenario is of disorderly defaults across the periphery followed by monetisation, a broad strategy of being short EUR, short bonds and long CDS suggests itself. Using Table 2 (PDF below) and idiosyncratic factors, this can be refined to provide a broad trading view for each sovereign. This is given in Table 1 (PDF below).
The views expressed in this article are the author's own and do not necessarily reflect Fair Observer’s editorial policy.
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