The market is getting ready to take on the European system and challenge the euro. The reason I've chosen that wording is because this could be a situation much like when a central bank intervenes to either protect its own currency or even stop its currency from strengthening too much. Whatever the situation, the central bank is effectively producing false liquidity on one side of the market. The same thing applies to interest rates where more liquidity or less liquidity is produced on one side of the market, providing a safety net for bond traders.
There are some ominous early indicators of what I think is about to happen. The Swiss franc has made a huge 8.5 percent gain against the euro in the last month as funds have moved to the franc for safety in lieu of traders getting a jump start on upcoming move against the euro zone by the markets. With both Merkel from Germany and Sarkozy of France saying that the euro is essential to Europe, it is like waving a red rag at a bull and the bull is the market. I will be very surprised if the markets do not force interest rates higher by raising the price of credit default swaps for Portugal and Spain.
Portugal could easily go the way of Ireland, which has been funded by the EU and the IMF. The difference is the Portuguese banks are not the problem as they were in Ireland, but Portugal might look a lot more like the Greek meltdown that is brought on by sovereign debt. If Portugal should have to take emergency funding, the euro will likely survive.
Spain is entirely a different case. Spain has maintained that its banks are strong. When we had the bank stress tests last year, the Spanish banks had to come back with restated numbers that got them to an acceptable rating. I do not see how the Spanish banks can be in a condition as strong as they suggest. The Spanish real estate market is far worse than that of either the U.S. or the UK. In 2007 it was estimated that the Spanish real estate market was 20 percent overbuilt compared to the demand, which fell off from the vacation home buyers for whom the homes had been built. Most of them came from Germany and the UK and to a lesser extent the rest of Northern Europe. I think the real estate portfolios of the Spanish banks have not been marked to market at real, current valuations. When and if this should happen, the negative effect on their balance sheets will surely impact Spanish debt ratings. The trouble is the numbers for Spain are at least four times bigger than those of Greece, Ireland and Portugal combined. Having put the size of the potential problem into some kind of context, if we take it one step further we get to the root of the problem which is the euro zone debt Ponzi scheme.
The week before Christmas there was talk in the markets about the viability of France! The reason was the amount of debt from other European countries the French banks and the Bank of France were holding and what would happen if some of this debt was devalued to levels that meant the bond holders would have to lose some of their rights as debt holders.
This whole set up looks like the Jenga blocks game. All someone has to do is find the block that makes the rest tumble. If the markets determine what that weakness is, then they will take on the European Central Bank (ECB) to force the issue. The ECB has almost no credibility due to its handling of the situation so far. All they can do is issue more debt to prop up those that could fail. This will dilute the value of the euro in the best case scenario. The worst case would be that by January 1, 2012, the euro would not exist in its current form. There may be a number of countries that have to leave and refloat their own legacy currencies. If the worst ships are not let go, they could sink the whole flotilla.
Another problem is that the German politicians do not have the people behind them. The French have the same issue, but it is not as bad as Germany. If it comes down to the core countries trying to stay together, the best case scenario is we have Germany, France, Holland, Austria, Italy, Belgium, Finland and Luxembourg left as the core (or tier one) euro members and the tier two would be made up of the rest. Those that have defaulted would be the tier three members who run with their own new, relaunched currencies, which they would try and keep semi-pegged to the euro. Once they have stabilized their economies they would be able to re-enter the euro with the tier twos. This would introduce enough flexibility in the system to allow it to work and stay together.
The problem is the big guys are talking up their resolve, which will likely only lead to it being challenged.
If the euro is held together, it will have to be with a more transparent structure. Some of the banks with a reputation of having the best currency forecasters suggest the euro will fall to 1.1800 at some point this year.
Even if this happens and the euro survives with its current structure, as we get hit by the different pieces of news — mostly related to sovereign and bank debt ratings — the bad news will cause a flight to quality. As we again flip flop between risk on (stronger dollar and bonds, weaker commodities and equities) and risk off, the mirror opposite of risk on. The other currencies will not follow the euro's moves as closely as they have in the past as negative euro news will be viewed as being very euro-centric..
The problem with all that will come is higher volatility. In times like these taking a conservative approach to currency exposures is only prudent. Unless you want to be in the risk business, don't be.
Some New Year resolutions are worth keeping more than others.
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