7 ways to trade a German U-turn

November 16th 2011: 7 ways to trade a German U-turn

There is little doubt that the Euro-zone debt crisis is reaching a climax. The signs of stresses are extremely clear and have intensified to a new and very dangerous level during the past few days. It is rapidly boiling down to a binary option of global financial meltdown or German rescue.

Risk conditions are set to get worse initially as fear intensifies with the Euro and commodity currencies particularly vulnerable to further losses over the next 24-48 hours, especially as it is unclear where the pain threshold is. There should, however, be major buying opportunities within the next few days as the German government and ECB are likely to cave-in and mount a rescue operation.

Sell German bunds at yields blow 1.70%. If Germany does shift course, there will be a massive reversal in German bonds as safe-haven demand will disappear, especially as inflation forecasts will be revised higher. Similarly, also look to sell US 10-year Treasuries at yields below 1.90% and buy Italian bonds at yields above 7.50%.
Buy USD/JPY below 76.50. If there is an improvement in risk appetite, defensive yen demand will weaken. Also buy Euro/yen near 98.50. The valuation grounds are extremely favourable as well.
Buy AUD/USD. Never a currency for the faint-hearted, but there should be a buying opportunity in the 0.96 region
Buy EUR/USD ahead of the weekend. There is always a bigger chance of a policy shift over the weekend which would trigger a market gap higher when markets reopen in Asia on Monday.
Buy EUR/USD on a selling climax to below 1.30. As a proxy, look to buy Euro/Sterling in the 0.8300 area, especially as safe-haven Sterling demand would decline.
Buy Euro/Swiss ahead of any reversal as the Swiss National Bank will be happy to take advantage of any Euro recovery and help push the franc to the 1.30 area.
There would be an important sigh of relief in Asia on any German policy shift. Look to sell USD/SGD above 1.32. Also, sell the US trade-weighted index (USDX) above the 80 level.

It is very clear that the markets have rejected the EU’s attempts to deal with the crisis and are in the process of voicing a massive vote of no confidence as hedge funds ratchet up the pressure. Talk of leveraging the EFSF through alchemy are dead in the water, the markets simply won’t buy it.

The widening of yield spreads has entered a terminal phase following Italy’s move into bailout territory above 7.0%. Spanish yields have risen sharply to well above the 6.0% level while there has been a big increase in borrowing costs for France, Austria and Spain.

There was an opportunity to restructure the Euro through an orderly Greek exit but the chance has been missed. Ironically, the situation is now so bad, that Greece may have bought extra time as the contagion risk is now severe.

On current trends, there will be another spate of credit-rating downgrades within weeks if not days and any remaining thoughts of EFSF rescue will evaporate once France loses its AAA credit rating.

If the Euro-zone were a local problem, then market forces could be given free rein with the Euro consigned to history. Ultimately, this remains a strong possibility, but the global dimension makes this crisis a very different order of magnitude.

The global banking sector is in danger of imploding on a scale that will make 2008 look like a small setback. One major implication of the crisis is that banks will have to re-price sovereign-debt risk. In previous models, sovereign debt was assumed to be risk free on bank balance sheets and could effectively be excluded when looking at capital adequacy ratios.

The latest bout of Euro-zone chaos, together with pressure for a larger write-down of Greek debt, has forced a re-pricing of sovereign risk and banks will not have the same freedom in the future. Although the immediate focus has been on the Euro area, sovereign debt as a whole will also have to be re-priced and there will be serious implications for the global banks.

There is an important risk that the already vulnerable global banking sector will face renewed and much more severe stresses as the sector has been fatally holed below the water line with a contraction in lending.

With the US still extremely vulnerable and China at severe risk of a hard landing, the global economy is in very poor shape to weather a credit crunch. Interest rates are already extremely expansionary and the route of increased fiscal spending has been blocked-off by the sovereign-debt crisis. In this context, international pressure on Germany will also be intense.

The pressure on Germany and the ECB for a reversal in policies will therefore continue to intensify. The German position remains eminently understandable from a long-term perspective, but the risks to the global financial system are now so high that ultimately there will have to be a u-turn and a commitment either to monetary financing or some form of Euro-bond, at least as a temporary measure, as the alternative is too costly even for Germany.

The German government will certainly look for further concessions and the ultimate price is likely to be a Euro-area break-up, but this needs to be done in the safety of calmer waters and not in the middle of the storm.

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