A Pair of Plays on Europe’s Turmoil

12/07/2011 9:00 am EST

Focus: GLOBAL

James Fink

Editor, Jim Fink's Options for Income and Stocks to Watch

If Europe continues to slide into recession, and especially if the EU summit this week disappoints, these related trades stand to profit nicely, observes Jim Fink of Investing Daily.

All eyes are on the European Union summit concluding this coming Friday in Brussels, where German Chancellor Angela Merkel and French President Nicolas Sarkozy will determine the fate of the Euro

Although calling the summit ”the last chance” to save the Euro may be a bit of hyperbole, Standard & Poor’s drew a line in the sand on Monday when it changed the credit-rating outlook for 15 Eurozone countries to “negative” from “stable.” A “CreditWatch with negative implications” designation means that there is a 50% chance that S&P will downgrade the credit rating within the next 90 days.

Most at risk is France, which could be downgraded two notches, but all five of the other triple-A rated Eurozone countries are at risk of a one-notch downgrade: Germany, Netherlands, Finland, Austria, and Luxembourg. The shocker is that Germany—the AAA financial pillar of Europe—is also at a risk of a one-notch downgrade.

Two of the reasons S&P gave for moving to a negative credit outlook were:

  • a 40% chance of a Eurozone-wide economic recession in 2012
  • the EU’s political paralysis over ensuring adequate bailout funds for “too large to fail” Italy and Spain

Disagreements continue among European policymakers on how to tackle the immediate market confidence crisis and, longer term, how to ensure greater economic, financial, and fiscal convergence among Eurozone members. S&P’s credit warning to Germany could not be more clear: provide a credible bailout mechanism at Friday’s meeting, or face the consequences.

The New York Times is reporting that Merkel and Sarkozy are pushing for EU treaty changes that will impose enforceable fiscal austerity on the weaker euro-backed countries in the Eurozone, but even Sarkozy admits such changes won’t be finalized until March 2012, and won’t be ratified by all 17 Eurozone until June 2012 at the absolute earliest. I don’t see how such a prolonged process will provide the immediate financial resources needed to save Italy and Spain from default.

The European Central Bank (ECB) is expected to cut rates for the second consecutive time at its Thursday meeting, and ECB chief Mario Draghi has indicated that the ECB will be more willing to buy Italian and Spanish government debt if it sees a viable political process to revise the EU treaty. So there is hope for some short-term relief.

Furthermore, the IMF disbursed $2.95 billion in emergency loans to Greece, and Italian ten-year bond yields fell below the dangerous 7% level on news that the Italian government had passed an austerity budget. But the real problem is lack of economic growth in the Eurozone, and these stopgap measures won’t solve that problem.

In fact, the austerity measures will make the problem of no growth worse. Austan Goolsbee, economics professor at the University of Chicago School of Business and the former chairman of President Obama’s Council of Economic Advisors, recently said that the ECB cannot save Europe and the euro is doomed.

The bottom line is that Europe is likely headed for both a severe economic recession and currency chaos. If Professor Goolsbee is right, the CurrencyShares Euro Trust (FXE) should decline over the next year from its already-depressed level.

Since the US dollar may not do too well either, it may be wise to neutralize the US dollar by doing a pairs trade. Short the FXE and simultaneously buy a strong currency like the CurrencyShares Swiss Franc Trust (FXF).

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