The Euro Is in Trouble: Part Deux

by Ivan Martchev | June 9, 2012 6:00 am

Saying that Greece caused the euro crisis is like saying that Lehman Brothers caused the financial crisis of 2008. The truth is that neither were causes, but both were (rather potent) catalysts of their respective financial imbroglios.

Lehman was the victim of total U.S. financial system leverage, which had been rising for 25 years and peaked at 385.7%[1] in the first quarter of 2009; total financial leverage in the system has been coming down ever since, to the present 354.7%. Leveraged balance sheets at the banking, overall corporate, governmental and consumer level sooner or later tend to result in leveraged debt liquidation, which Lehman notably accelerated with its unfortunate failure.

Greece accounts for only 2.65% of eurozone GDP, but the rounding-error status of the dirtiest of the PIIGS is not what is relevant here. It is the precedent for leaving the monetary union that is the issue, as Italy and Spain both comprise 17% and 11.7% of eurozone GDP and taken together are bigger than the strongest eurozone economy Germany (26.7%). Suffice to say that if either Spain or Italy or both leave(s) the euro, the common currency is unlikely to survive.

When I wrote “The Euro is in Trouble”[2] on March 12, 2009, there was no Greek default and PIIGS had not yet become a well-known term. But precisely the conditions that prompted me to write this missive have brought the present crisis, and I am sorry to report that none have been addressed.

The euro was designed with a potentially lethal flaw, where 17 different divergent fiscal policies — sometimes in direct contraction with the spirit of the monetary union — were accompanied by a single monetary policy. The acceptance of formerly weak-currency PIIGS countries in the monetary union initially caused their domestic interest rates to drop, fueling asset bubbles whose unraveling is causing serious strain on their financial systems at present. Lower interest rates induced unsustainable government borrowing that also added to the problem that grew over a decade of common currency.

Ironically, it was the the unwinding of financial-system leverage in the U.S. catalyzed by the Lehman failure that set off the necessary ripples to start this eurozone crisis.

What are the odds of the euro falling apart? For that, we look at the sovereign bond markets, which have been signaling increasing likelihood by the day. Two-year German government bond yields are at 0% — yes, zero percent — while the same maturities in Italy and Spain yield 4.1% and 4.85%.

But it is not the absolute level of interest rates that signals rising stress in Europe. The interest rate differential between German bunds and Spanish 10-year bonds is reaching all-time highs[3], and the one with Italian bonds is rising again[4]. Investors would rather lend money to the German treasury for free to avoid the risk of taking an immediate currency discount in historically weakish southern European currencies in the event of euro secession by either Spain or Italy.

What is more extreme, investors would rather pay the Swiss treasury 0.29% per year for two years to hold their money for them to avoid the currency risk. The temporary stabilization[5] brought on by the deployment of 1% LTRO funds did absolutely nothing to resolve the European situation.

What Now?

The Greek election on June 17 certainly is a big focal point where anti-bailout parties better not get majority in parliament, as this would raise the odds of the ultimate euro secession domino effect. The rising stress in the Spanish banking sector where a run of unstable banks is ongoing is another issue to keep on your radar.

As mentioned before[6], long-only investors need to stay away from problematic global financials and focus on those that that have no credit risk on their balance sheets — like MasterCard (NYSE:MA[7]) and Visa (NYSE:V[8]). As for European investments in general, the purchasing power parity (PPP) of the euro for the total eurozone, according to OECD, is at about $1.25. It is easy to see how all this stress in Europe is likely to drag the common currency below PPP as the drama is ongoing. The depth and speed of the euro decline is dependent on if/when countries begin to leave the monetary union.

The most problematic stocks to hold in such an environment are European financials, whose ADRs are coming under pressure because of a decline in the currency as well as intensifying issues with their balance sheets.

A complete disintegration of the euro that goes back to the original currencies that made up the eurozone is a step in the direction of a disintegration of the European Union itself. While such an outcome is a low probability at present, the developments over the past two years certainly have made it a possibility. This is why 10-year German bunds — the safest euro-denominated sovereign bonds — have defied gravity and been bid up to unseen heights with yields dropping to 1.17%.

The decline in 10-year Treasury notes to 1.44% in June is due to a flight of capital out of European sovereign debt markets, as Treasurys still are the most liquid non-euro denominated debt instrument. Government bonds like bunds and Treasurys that offer safety in such an environment can see yields fall to even more absurd levels should the situation continue to escalate.

The ultimate safe haven asset — gold bullion — has not been a great performer[9] in the present environment. This is because the outflows from in euro-denominated assets have pushed the U.S. dollar higher, which historically has not been bullish for gold. Still, it has to be mentioned that gold bullion is the only asset that is not also a liability on anyone’s balance sheet, so it does offer a hedge in the present environment, as a gold bar cannot fail in the financial sense of the word — it still will be here after this crisis is over.

Do not confuse silver, palladium and platinum with gold in the present environment, as I have noticed that in calmer times they trade like precious metals, while under rising financial system stress they begin to trade like industrial metals. During the past 12 months, as the euro crisis has been intensifying, silver, platinum and palladium all are down more than 20%, while gold still is up around 5% despite the recent pullback. The same goes for gold stocks, which are leveraged investments and can be quite a bit more volatile than bullion itself.

As this crisis unfolds, the unlikely trio of U.S. dollars, Treasurys and gold can offer a necessary hedge.

Ivan Martchev is a research consultant with institutional money manager Navellier & Associates. The opinions expressed are his own. Navellier & Associates holds positions in MasterCard and Visa for its clients. This is neither a recommendation to buy nor sell the stocks mentioned in this article. Investors should consult their financial adviser prior to making any decision to buy or sell the aforementioned securities.

  1. and peaked at 385.7%:,id:us_total_debt_gdp,calc:&zoom=5&startDate=&endDate=&format=real&recessions=false
  2. “The Euro is in Trouble”:
  3. all-time highs:
  4. rising again:
  5. temporary stabilization:
  6. mentioned before:
  7. MA:
  8. V:
  9. not been a great performer:

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