Why It’s Time to Short the Euro

04/25/2011 11:33 am EST

Focus: FOREX

The markets aren’t pricing in the risk that comes from lingering euro zone debt concerns and the likelihood for default, says one trader, making a case for the euro being far overextended and ripe for a short play.

Over the last three months, the euro has appreciated 10% against the US dollar and by smaller margins against a handful of other currencies. Over the last 12 months, that figure is closer to 20%.

That’s in spite of anemic euro zone GDP growth, serious fiscal issues, the increasing likelihood of one or more sovereign debt defaults, and a current account deficit to boot. In short, I think it might be time to short the euro.

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There’s very little mystery as to why the euro is appreciating. In two words: interest rates. Last week, the European Central Bank (ECB) became the first G4 central bank to hike its benchmark interest rate. Moreover, it’s expected to raise rates by an additional 100 basis points over the next 12 months.

Given that the Bank of England, Bank of Japan, and US Federal Reserve have yet to unwind their respective quantitative easing programs, it’s no wonder that futures markets have priced in a healthy interest rate advantage into the euro well into 2012.

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From where I’m sitting, the ECB rate hike was fundamentally illogical, and perhaps even counterproductive. Granted, the ECB was created to ensure price stability, and its mandate is less nuanced than its counterparts, which are charged also with facilitating employment and GDP growth. Even from this perspective, however, it looks like the ECB jumped the gun.

Inflation in the EU is a moderate 2.7%, which is among the lowest in the world. Other central banks have taken note of rising inflation, but only the ECB feels compelled enough to preemptively address it.

NEXT: Slow GDP Growth and Ongoing Bailout Buzz

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In addition, GDP growth is a paltry .3% across the EU, and is in fact negative in Greece, Ireland, and Portugal. As if the rate hike wasn’t bad enough, all three countries must contend with a hike in their already stratospheric borrowing costs, ironically making default more likely. Talk about not seeing the forest for the trees!

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If the rumors are true, Portugal will soon become the third country to receive a bailout from the EU. (It should be noted that as recently as November, Portugal insisted that it was just fine and that a bailout wasn’t necessary). Its sovereign credit rating is now three notches above junk status.

Last week, Greece became the first euro zone country to be awarded this dubious distinction, and Ireland is now only one downgrade away from suffering the same fate.

Of course, Spain insists that it is just fine and denies the possibility of a bailout. At this point, though, does it have any credibility? Based on rising credit default swap rates (which serve as a gauge of the probability of default), I think that investors have become a little more cynical about taking governments at face value.

I have discussed the fiscal woes of the euro zone on my blog, and don’t want to dwell on them here. For now, I’d only like to add a footnote on the extent to which their problems are intertwined. 

Banks in Germany and France (as well as the rest of the EU) have tremendous balance sheet exposure to PIGS’ (Portugal, Ireland, Greece, and Spain) sovereign debt, which means that any default would multiply across the euro zone in the form of bank failures. (You can see from the chart below that the exposure of the US is small, relative to GDP).

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Some analysts insist that all of this has already been priced into the euro. Citigroup said, “The market is treating many of these [sovereign credit rating] downgrades as rearguard actions which are already well discounted.”

Personally, I don’t think that forex markets have made a sincere effort to grapple with the possibility of default, which appears increasingly inevitable. In fact, when S&P issued a warning on the US AAA rating, traders responded by handing the euro its worst intraday decline in 2011.

Any way you cut it, I think the euro is overvalued. Regardless of what the ECB is doing, market interest rates don’t really confer much benefit to those holding euro. Even if the rate differential widens to 1%-2% over the next year (which is certainly not guaranteed, as Jean-Claude Trichet himself has conceded), this isn’t really enough to compensate for the possibility of default or other risk event.

Regardless of whether you want to be long or short risk, there isn’t much to be gained at the moment from holding the euro.

By Adam Kritzer of ForexBlog.org

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