Doubling Down Against the Euro

02/22/2010 11:00 am EST

Focus: ETFS

Nicholas Vardy

Editor, Bull Market Alert, The Alpha Investor Letter, and The Global Guru

Nicholas Vardy, editor of Global Stock Investor, says the euro may be heading for a crisis, and he recommends a risky, leveraged way to bet against the single currency.

Recent economic troubles around its periphery certainly qualifies as Europe’s (and the euro zone’s) most serious economic challenge since the introduction of the euro 11 years ago.

Today, Greece has been grabbing headlines as the latest example of Europe’s woes. After October’s election, Greece’s new government dropped a bombshell: Greece’s true fiscal deficit was likely to hit 12.7% of gross domestic product—in the same ignominious league as the US and the UK. Rating agencies Fitch and S&P cut Greece’s grade from A- to BBB+.

The “bond vigilantes” came out in force, sending the yields on ten-year Greek government bonds soaring to 7.1%—about four percentage points more than that on German bonds, the gold standard of fixed-income investing in Europe.

If the Greeks do not regain the markets’ confidence, they may fail to refinance the €20 billion ($28 billion) or so of debt that falls due in April and May. At that point, the Greek government would have to default on its debts or be bailed out.

The European Union doesn’t have a unified structure to deal with economic crises. No wonder the International Monetary Fund (IMF) was forced to bail out a handful of Eastern European countries [last year].
 
Both the US and the UK can print their own money during economic crisis. But by ceding control of their currency to the European Central Bank (ECB), individual euro zone countries like Greece don’t have that option.

Even though Greece only represents 2.5% of Europe’s GDP, if it goes bust, the cost of borrowing for other troubled euro members would shoot up. If Greece did attempt a debt restructuring, Italy, Spain, Portugal, and Ireland would be next. That would mean a combined $2 trillion of potential sovereign debt restructuring—more than triple the $600-billion direct cost of the Lehman [Brothers] bankruptcy.

Traders and hedge funds have bet nearly $8 billion (€ 5.9 billion) against the euro, amassing the biggest-ever short position in the single currency on fears of a euro zone debt crisis. Having soared to around $1.60 in 2007, the euro now trades at about $1.37.

To profit from the euro’s fall against the US dollar, buy the UltraShort Euro ProShares (NYSEArca: EUO) and set your stop at $18. (It closed below $21 Friday—Editor.) This ETF seeks to replicate, net of expenses, twice the inverse performance of the euro’s daily price change [against the US dollar]. That means that for every 1% weakening of the euro relative to the dollar, the price of the ETF will generally increase by 2%, and vice versa.

So, if the euro declines 10% from its current level of $1.37 to the US dollar to, say, $1.24, you can expect to lock in a gain of twice that amount with this ETF—that is, about 20%.

(Editor’s note: Double inverse ETFs sometimes don’t accurately track the indexes they follow and are highly volatile, so they should be held only by risk-tolerant investors who monitor prices closely.)

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