Reverse Psychology

I just saw Dennis Gartman (aka the world’s most pompous commodity trader and author of a commodities trading newsletter) on CNBC. He expressed his shock and disbelief that the Euro has stayed strong against the dollar. This probably means Gartman is short the Euro, and therefore losing money, which is why he can’t believe it, but on the surface I would have to agree with him. If there is one place in the world with bigger financial problems than the U.S. it has to be the EU. The market for Greek debt is clearly pricing in a default, and the logical solution for Greece is to leave the Euro and devalue a new Drachma. The ECB keeps reiterating that any default (technical or otherwise) on Greek debt will make it no longer eligible as collateral for European banks at the ECB. Irish voters seem to slowly be awakening to the fact that letting their banks default on their debt to the rest of the EU would probably work out pretty well for Ireland (although likely not for the rest of Europe). Spain and Portugal aren’t far behind. Voters in Finland and Germany are already revolting over the potential cost of bailing out these spendthrift nations. Etc. Etc. How can the Euro be going up?!?!?

Well, what is likely to happen to resolve all this? At the macro level, either Germany and the other strong Euro nations bail out Greece and the weak Euro nations, or else they don’t. Clearly the rates on Greek debt indicate that the market is betting they won’t, so let’s look at that scenario first. If Greece defaults, the government will not be able to borrow any more money. Since they can’t balance their budget, and they can’t print Euros. They will have to reinstitute the drachma and set an artificially low official initial exchange rate at which to convert Greek debts from Euros into drachmas. If you own a 1,000 Euro Greek bond, you will get drachmas in repayment that are worth 600 Euros on the open market. If you have 1,000 Euros in a Greek bank, you will be given drachmas in their place that quickly become worth 600 Euros. There will be riots in streets. Tourism to Greece will plummet. It will be ugly for Greece. Spain and Portugal will see this and either get their act together, or else decide to leave the Euro on their own terms before it is forced on them in the same disastrous way it was forced on Greece.

If this occurs, the ECB will have to bail out many banks in the rest of Europe that hold Greek, Spanish, and Portuguese debt, but it would be more palatable to Germans to be bailing out German banks rather than the Greek government.

In this scenario the market disruptions and dislocations would be huge. It is not hard to imagine the Euro getting hit by 10% or 20% against the dollar in a single day. But maybe not, because the market might realize that once the smoke clears you will be left with the core of the EU in much better shape than today’s EU, with just the healthier economies and government balance sheets remaining. All of that would seem to argue for a stronger Euro.
What about the alternative scenario, where the EU does bail out Greece et al? This would equate to printing Euros, which will stimulate demand and the money supply. To avoid inflation in Germany and the other healthy growing economies, the ECB might have to raise interest rates at least a bit. Rising interest rates vs. the near-zero rates in the U.S. would again argue for a stronger Euro against the dollar, not a weaker one.

So while the EU is indeed a mess, the short-Euro trade is not such a no-brainer… as Dennis Gartman has apparently learned as well.