Thursday, May 3, 2012

Why the EUR is likely to go bellow parity with the USD

Some people asked me why short EUR, my hunch was that the panic there would lead to capital outflows. Let me articulate a bit better
Lets say Greece drops out of EUR, depositors and people who hold financial assets(Lets call them DC Devalued Citizens) will face an overnight loss of something like 60% in their wealth. Non-devalued citizens(ND) will begin to wonder about their own wealth

ND with assets in countries with high spreads over bunds will begin to fear for their own wealth, the correlation between fears and people moving out of their assets from those countries will rise. They will do the following things most of the time:
-Buy EUR denominated debt or deposit it in 'safer' countries
-Buy USD
-Buy real assets

But my bet is that when an actual departure from the EUR occurs the level of panic in the high spread countries will be so high that German yields will be driven to absurdly low levels(They are already quite absurdly low). Their real interest rates will collapse for many years out the curve. Low real interest rates will be so bad relative to the US that it will drive flows to the USD. Effectively the people there will be enacting many rate cuts, that is usually bad for the currency

But there are other effects, when a country leaves they are also defaulting in loans by paying in a devalued currency so the banks of other countries who hold those debts will face losses. This means that the pool of 'safe' countries that ND can invest their EUR wealth will decrease(As they have to bail out their banks and people fear that the banks are not safe, perhaps France will be in this category) when the amount of countries where there is a risk(even if the risk is small) will increase. This will only encourage the capital flows to go towards the USD and Real Assets(Will also compress the yields in the remaining safe countries even further)

When the first country leaves and people see the loss for the DC, having money in EUR will be like being in a mine field where you don't know where the mines are. There is a haven(Germany) but if everyone piles up on the same place its valuation looks worse and worse. This would be excellent for USD and gold
To me this mine field analogy is the real killer. IME people totally hate to lay odds in bets, everyone wants to bet getting 6-1 on their money not offer 6 for everyone 1 that is bet. 

Having EUR on a country that can devalue will be effectively laying odds on your wealth. You can lose a lot to make a little. This is also why there are excess returns in stocks that have uncertainties in them, they are sold to levels bellow their fair value because people hate a small gain if there is a significant chance of a large loss
This analogy does not apply to extremes, people will lay 100-1 if the chance of the large loss is really small, they will pick pennies in front of a truck sometimes. But the fact that they just saw a devaluation will change things, because now they will be afraid and will increase the probabilities in their minds of the large loss

I believe even the market agrees with my view. Back when Greece was threatening a EUR referendum and full default the EUR dropped 500bps in a few days. Its a matter of what the probability is, the market thinks its small so they keep the currency at the current level. I believe its much higher so I'm short and I expect it to collapse bellow parity IF I'm correct some countries will leave
Other interesting ways to play this trade
-Buy black swan type long-term puts on EUR
-Short right after a country leaves, the currency will probably be down a lot that day, if feels un-natural to 'chase' the trade. But just imagine the people with huge EUR portfolios who now might want to liquidate. For them as a whole its going to take many days if not much longer


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