It was a wild first week of May for the markets as investors’ fears about debt problems in the Eurozone intensified. A nearly $1 trillion bailout package quickly brought market stability, but I think it might prove to be just a band-aid for the Eurozone and not a cure.
It’s difficult to find details of how this bailout will function. There isn’t much clarity about how the money will be used, but we do know the amounts pledged and from where. Here is a breakdown.
€440 billion government-backed loans (primarily from France and Germany)
€60 billion from European financial stabilization fund
€250 billion from the International Monetary Fund
There are a few other methods being used to stabilize the market. Open-market operations involve buying both government and foreign debt of various types. When you purchase a bond, raw cash enters the marketplace, so the European Central Bank is attempting to create liquidity.
Long-term refinancing operations are also on the table for nations who can’t meet their debt obligations. Italy, Greece, Portugal and Spain are the countries thought to be the most vulnerable right now and most in need of this option. Reopening of U.S. dollar swap lines with the Federal Reserve and other major central banks was also discussed as a way to help provide liquidity, although not part of the formal bailout package.
The bailout is an interesting idea, but whether it will have real lasting impact remains to be seen. Greek interest rates had climbed to astronomical levels, making it difficult for the government to balance the budget. In the chart below, you can see how interest rates in the “PIGS” nations have spiked, then retreated after the bailout announcement. The white line represents the yield on one-year interest rate on government-secured Greek debt. It’s at about 7 percent, still well above historical levels of about 2 percent but down from its peak of about 16 percent. Spain is represented by the orange line, Portugal the yellow line, and Italy the green line. You can see how rates in all these countries have fallen, and from this perspective, the bailout package has been effective.
The market has provided lower interest rates, but it’s not without cost. Inflation is usually the result of such actions. The amount of the bailout is large by any measure, but especially considering that the countries needing this much assistance are small. We are essentially solving a debt problem by throwing more debt at the problem. The problem is that the miracle of compound interest works both ways.
Currency Impact
I believe these bailout measures are a temporary fix and will delay the onset of a financial crisis in Europe for about six months to a year. Ultimately, these debts have to be repaid. If Greece doesn’t change its spending habits, the situation could go from bad to worse. If we see the same problems unfold in Spain, a country that’s five times the size of Greece, the European Central Bank might not be equipped to deal with it.
The euro currency reached an extreme low on Thursday, May 6, the worst stage of the panic. The market rebounded on the bailout news, but it is nowhere near stable. If the euro does see a rally, I think corrections will be temporary, and should be viewed as selling opportunities. Selling into euro rallies could a be a popular strategy in coming weeks and months, as I don’t see any reason for the euro to strengthen much given the uncertainty in the region.
Debate about whether the Eurozone will hold together continues. The problems with a single currency are similar to those with currencies with a fixed rate. The Eurozone is made of countries with separate economies, and fiscal policies, all in essence maintaining a fixed exchange rate. When one country has problems, it’s currency doesn’t act as a shock absorber, which a country with a floating currency would have. If Germany is doing well while Greece is doing poorly, the currency will move in the opposite direction to what is needed to improve the Greek economy. A country with a floating currency and independent central bank can avoid debt default by printing its way out of a crisis—albeit as a solution of last resort.
I think the Eurozone will face serious challenges holding together in its current state, and the euro currency will continue to decline. It’s still at a high level compared to its historical patterns, and has room to move lower.
Canada Dollar Strategy
When looking at the global market’s reaction to the issues unfolding in the Eurozone, comparisons are made to the financial crisis of 2008-2009. Commodities sold off, and the Canadian dollar also sold off. At that time the U.S. housing/mortgage market was the source of the problems, and the U.S. is Canada’s best trading partner. While the Eurozone isn’t as significant to Canada, at this time, we have to be ready for the possibility the Canadian dollar could sell off regardless. If this situation compounds and investors become fearful, there will likely be a flight to the U.S. dollar, which we have seen time and again.
The U.S. has now gone through some pain and adjustments in their economy and now Europe is playing some catch-up to pay for their challenges. That’s not to say the U.S. doesn’t have issues surrounding its fiscal deficit, but at least the economy seems to be improving. If a second financial crisis occurs out of the Eurozone and results in a double-dip recession, traders might consider going long the Canada dollar and short the euro as a possible strategy. I believe the euro should fall faster than the Canadian dollar.
If the market do stabilize and the austerity measures in Europe work, Canada also looks to benefit from potential inflationary trends in commodity prices. I still think Canada is a good bet, but you have to hedge it against another currency (other than the U.S.).
Gold
Gold has been an interesting market, with a phenomenal ability to creep up, and then surge dramatically before many investors can get in on the move. Gold has recently hit a new record high above $1,240 an ounce. However, the move has been on light volume, and typically a strong bull market should see a bit more frenzy. It’s a good safe-haven market and could easily go to $1,300, but with the market at record highs a correction could come at any time. At the same time, shorting gold given the volatile situation in the Eurozone is a tricky game. As a trader, you can wait for a correction or you can look elsewhere for opportunities, but avoid joining a trade that is this far along.
Aaron Fennell is a Senior Market Strategist based in Lind-Waldock’s Toronto office, and is serving clients in Canada. If you would like to learn more about futures trading you can contact him at 877-840-5333, or via email at afennell@lind-waldock.com.
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